Liquidity Risk Sovereign Risk And Sub Prime Crisis Finance Essay - Free Essay Example

Sample details Pages: 5 Words: 1486 Downloads: 8 Date added: 2017/06/26 Category Finance Essay Type Narrative essay Did you like this example? It is said that when the U.S. sneezes everyone catches a cold. This motto has never been truer than nowadays when the world economy is struggling with one of the biggest financial crises ever. Such a crisis happened after risky loans granted in the U.S. reached alarming proportions. The US financial sector entered a grave credit crisis after a strong speculation in the real estate industry. The situation worsened with the bankruptcy of world financial giants such as Lehman Brothers and AIG in 2008. At the center of the subprime crisis there is an excessive liquidity risk, the risk that the market would be unable to turn investments into money cheaply, quickly, and at a fairly predictable price. It is opportune to highlight that the rise of liquidity risk had its roots in two linked phenomenons. Firstly, commercial banks lost their typical function of collecting and converting savings into productive investments which would generate funding liquidity for investo rs. Secondly, the noteworthy development of the so-called Shadow Banking System, a innovative financial engineering used by financial institutions which rivaled a fragile banking system and, created easier credit conditions by avoiding public-sector backstops and regulation (Federal Reserve Bank of New York, 2010) Ever since the US government decreased the cost of money to foster its economy after the September 11, financial intermediaries have played a role that all investors took advantage of: to create new financial instruments to manage and hedge risk for instance counter-party and default risk in the case of CDS (Credit Default Swap), by using a traditional market such as credit. Banks converted long-term assets such as mortgages and loans into marketable securities exchanged and sold to capital market investors (securitization) (Langley, 2010, 78). This financial practice made investors double their money and became very popular. In fact, over the last decade innovative assets such as subprime mortgages-backed securities (MBS) increased from $52 billion in 2000 to over $507 billion in 2005 (Eerden, 2009, 130). However, when the US housing market experienced a fall due to rising loan-defaults of low-credit-rating borrowers (classified as subprime), the value of the underlying assets of MBS and other structured asset-backed securities such as CDO (Collateralized Debt Obligation) dropped dramatically over a short period causing heavy losses. CDS were the last straw. Given that they were new financial instruments which lacked of government regulations and schemes to determine their value, price movements and the speed at which investors could dispose of their assets changed rapidly. Thus liquidity risk rose since assets prices and loss-values were unpredictable. Uncertainty on loss exposure made these assets go for sale quickly and drained liquidity from the market by causing volatility and insolvency. Investors were clearly not interested in these assets anymore and this led to one of the main sources of liquidity crises (Nikolaou, 2009, 4): market incompleteness, a situation where there are no markets on which financial assets can be easily traded because of the lack of buyers and therefore the ability to hedge liquidity risk is very low. On the other hand, what contributed to boost liquidity risk was also the asymmetric information between CDO issuers and potential buyers. Due to a structured finance, CDO issuers were the only players who were able to analyze the value and risk level of the assets underlying CDOs (Beltran and Thomas, 2010, 21). Not only did buyers not have enough information and tools to explore the value of these innovative and structured securities, but they were also exposed to a mispricing risk, due to altered ratings from qualified agencies such as Moodys, Standard and Poors and Fitch which increased their profits by overrating the value and quality of CDOs. Although liquidity risk occurs in the banking sector of a country, it is intimately related to the governments risk such as sovereign risk. Unlike corporations, governments can discretionally issue laws and policies that allow them to break, within their jurisdictions, debt contracts. This happens by declaring default or restructuring unilaterally the contract terms (extending deadlines or modifying yields) on determined securities of the public debt. When the market experiences massive liquidity falls, governments represent the first line of defense through central banks which are required to intervene by ensuring large amounts of capital to lending institutions in order to meet their investors needs. During episodes such as the subprime crisis featured by illiquidity amongst financial institutions, governments make great efforts by using public spending and might run into debt with increasing fiscal liabilities and budget deficit (Arghyrou and Kontonikas, 2010, 6). Lenders may start fearing the possibility that a sove reign government, in which they invested, may default because of its incapacity to fund its debt and ask for massive international bail-outs as happened for bankrupted Greece. Increasing fears that the government would not be able to refinance the banking system raise what is called sovereign risk. Therefore liquidity risk is one of the main components that influence sovereign risk. Since investors bear higher risk due to potential defaults, they demanded higher yield premiums on sovereign bonds and this makes the debt even more expensive and the probabilities of default risk rise. This justifies the high 10-year bond yields that some peripheral EU countries at stake such as Ireland with 7.14 percent and Portugal with 6.11 percent are now facing (Financial Times, 2/11/2010) Furthermore, fluctuating exchange rates experienced over the last few years (e.g. UK currency), increased sovereign risk since the risk of collapse of financial markets caused by illiquidity hit a large market such as bond markets. In fact as Arghyrou and Kontonikas (2010, 3) state, the EMU debt crisis can be seen as a currency crisis in disguise Within the eurozone, one of the countries that has been little damaged by the liquidity crisis is Italy. Italy has traditionally been featured by a prudent credit system and an above-average saving propension. Therefore banks finance themselves by having recourse to clientele deposits as funding source. Furthermore, unlike the US, loans can only be granted to those with high credit ratings who prove to be able to meet their obligations. Moreover borrowers can obtain loans only if they meet the income requirement. Therefore it is right to speak of prime loans and not subprime loans. As soon as the liquidity shortfall became an insolvency crisis, the Italian Government, in agreement with the Central Bank, swiftly intervened by paying special attention at the undeserving institutions with the highest insolvency. In order to ensure liquidity in the financial system, the Government has introduced the so-called Tremonti Bonds, which are bonds issued by Italian banks and underwritten by the Italian Treasury with the aim of enhancing banks core equity capital and supporting the supply of credit towards families and businesses. In addition, as other EU central banks, the Italian Central bank has followed the new policies established by Basel and the European Union. According to Nout Wellink, chairman of the Basel Committee on banking supervision, global regulators will not finish their package of capital surcharges and other safety measures for banks deemed too big to fail until mid 2010-11 (Financial Times, 20/10/2010). Throughout the crisis the world regulators such as Central Banks, the European Central Bank (ECB), and Federal Reserve (FR) have been strongly committed to provide unlimited liquidity in the banking sector and guarantee non- insolvency crises. Furthermore, the ECB, in order to prevent the Euro-zone fro m potential defaults and give more peace of mind to investors, created a ÃÆ' ¢Ãƒ ¢Ã¢â€š ¬Ã… ¡Ãƒâ€šÃ‚ ¬750 billion fund for EMU countries that might be at stake within the next three years (Arghyrou and Kontonikas, 2010, 10). In order to support credit towards businesses and households, according to the 2009 ECB report, the monetary policy has been eased with unprecedented measures: unlimited liquidity provision at the key interest rate of 1 percent, extended the average deadline for refinancing operations, broadened the range of assets accepted as collateral which implies that banks will have access to central banks liquidity more easily. Moreover, the ECB and other central banks provided liquidity in other currencies such as US dollars. Overseas, the FR has responded with an aggressive monetary policy ever since August 2007 by reducing the federal fund rate from 5,25 percent to effectively zero (Federal Reserve, 5/2/2010). The illiquidity has been tackled with the implementat ion of two special liquidity schemes such as The Term Auction Facility and The Term Security Lending Facility. The first, designated for depositary institutions, consists of auctioning funds, such as collateralized short-term loans, to safe institutions. The second allows investors to exchange collateral with less risky assets such as Treasury securities. Over the last decade, developed countries lived well beyond their possibilities whilst until the end of the last century it was common to spend in accordance to income. However, in most recent years overspending became popular by recurring to loans in order not to make any renunciation. The economy based on real data, labor, and productivity has been replaced by a creative finance. The new financial engineering gave life to authentic monsters, such as financial intermediate practices mostly aimed at selling worthless and unmarketable tools whose usage has been too irresponsible. Don’t waste time! Our writers will create an original "Liquidity Risk Sovereign Risk And Sub Prime Crisis Finance Essay" essay for you Create order