In 2008, a number of financial institutions including insurance companies, mortgage companies and banks failures generated a financial crisis, which brought to a halt the world’s credit market. The financial crisis originated from subprime lending crisis and real estate. The real estate values increased continually since the 1990s leading to serious demand for the estates. The rise in value of the properties coincided with the financial institutions lowering their lending standards to finance the mortgages (Sun, Stewart & Pollard, 2011). The financial institutions also reduced the interest rates to allow people access the mortgage facilities.
The financial institutions allowed unqualified people access the mortgages despite their poor credit history. People with low incomes usually referred to as the first generation immigrants also accessed mortgages, leading to the rapid expansion of subprime market. Financial institutions, like the mortgage companies and the banks, paid their sales people generous commissions to encourage them make more sales. These people would deliberately hide the cost of adjustable mortgage rates and did not strictly scrutinize the buyers to determine the repayment abilities in the future. They even ignored feeble lending tests.
The mortgage companies offered affordable, adjustable interest rates for the first two years, but this rate was adjusted later making repayment more expensive. Inflationary pressures pushed the interest rates up to 4%, which made repayment unaffordable, since many people had large repayments. This led to an increase in the number of defaulters. As the number of defaulters went up, the increase in house prices stopped. Consequently, the values of the properties stopped rising, the borrowers were unable to make their payments forcing the financial institutions recognize heavy write offs and write downs, which found the financial institutions on the verge of bankruptcy.
The decline in property prices came at a time when there was a boom in construction of new homes, up until 2007. Demand for the houses decreased while supply increases, which in turn forced prices of the properties to collapse. As prices fell, loan repayments became harder and harder leading to an increase in the number of defaulters (I.M.F, 2009). Mortgage companies were in most cases forced to take back the loan through the sale of the houses, however, the value of the house was too low to cover the amounts of the loan. This left many companies in serious financial crisis, which translated to the worst financial crisis in the world.
The mortgage companies borrowed funds from other banks to issue mortgages to their clients, through the sale of collateralized debts. This meant the banks shared the risks of the subprime mortgages. The risk agencies gave the debts a triple A safety rating, so the banks did not know the risk their financial position was facing. When the defaulters increased, financial institutions had to write off the bad debts, which caused massive financial losses. IMF estimates that the losses from the bad debts amounted to 1.3trillion pounds.
Since the banks experienced massive losses, their balance sheets deteriorated and became impossible to lend money to other banks and people, leading to liquidity shortage in the money markets. Banks sold their assets to raise finances, which further reduced the prices of property. This worsened the balance sheets. People started selling their banks shares due to lack of confidence, which resulted in loss of share prices for banks’ shares. The fall in house prices, collapse investor confidence and finance shortage forced a decline in the real economy. Consumer spending and investments fell forcing leading economies into recession and increasing unemployment (Sun, Stewart & Pollard, 2011).
The financial institutions played a significant role in the recovery from the recession and financial crisis they initiated. The crisis was managed through a combined use of monetary and fiscal policies, whose success is determined by the participation of financial institutions. The Federal Reserve and central banks of different countries use their ability to alter rates of interests to stimulate economic growth across the globe. The central banks hold short-term interest rates and discourage the long-term rates to avail funds for investments. The Federal Reserve brought in new rules that reduced the interest rates, so that investors would be able to access funds easily and invest. They also purchased a lot of securities and created new lending platform to avail funds to people easily .
The financial institutions received loans from Fed at very low interest rates and lend the money in form of loans and investments with enormous returns. Inter-bank interest rates were also reduced to zero to enable banks access funds easily. This is because; banks depend majorly on each other for loans. The banks and financial institutions were, therefore, able to provide credit to the economy, which assisted in recovery from the crisis. The money availed to investors was very extremely in recovery from the recession and improved employment levels (I.M.F, 2009).
FDIC worked to minimize the financial crisis by guaranteeing bank debts and through an increase in the deposit insurance limits. This would protect the financial institutions against losses. The banks also conducted stress tests in 2009 to determine their financial and capital positions and when the results were made public, restoration of confidence in the banking sector begun (I.M.F, 2009). An increase in investor confidence meant that investors were willing to invest their funds in the banking sector, which in return, would result in an increase in money supply in the economies. Banks also sourced for funds from other non-financial institutions and foreign investors in an attempt to raise additional capital to finance their operations and grant loans to investors.