Causes of Problems for Financial Institutions during the Financial Crisis : Brie

Question

Causes of Problems for Financial Institutions during the Financial Crisis: Briefly discuss the financial crisis. Determine and discuss the underlying causes of problems experienced by financial institutions during the recent financial crisis. Explain how these problems might have been avoided.

Impact of Financial Crisis on Financial Market Liquidity: Explain the link between the financial crisis and the lack of liquidity in the financial markets. Specifically, offer some insight as to the reasons the debt markets became inactive at the time. How were interest rates affected? What happened to initial public offering (IPO) activities during the crisis peVriod?

Risk Management: Discuss whether or not institutional investors that purchased mortgage-backed securities containing subprime mortgages followed reasonable investment guidelines and risk management. Address this issue for various types of financial institutions such as pension funds, commercial banks, insurance companies, and mutual funds.

Explanation / Answer

Financial crisis can be caused by different activities happened in the financial marketduring financial crisis all the things might not cause the crisis but some causes were essential,others had only minor impact. Some regulatory changes related to housing or the financial system prior to crisis. The amount of financial regulation should reflect the need to address particular failures in the financial system. political situations also case the financial crisis.

Yes, the financial crisis will have lots and lots of effect on the financial institutions Financial institutions concentrated correlated risk. Managers of many large and midsizefinancial institutions in the United States amassed enormous concentrations of highly correlated housing risk. Some did this knowingly by betting on rising housing prices, while others paid insufficient attention to the potential risk of carrying large amounts of housing risk on their balance sheets. This enabled large but seemingly manageable mortgage losses to precipitate the collapse of large financial institutions

liquidity risk. In this the companies shares bonds and securities will be effected much because of the crisis .the firms liquidity also effecte, Managers of these financial firms amplified this concentrated housing risk by holding too little capital relative to the risks they were carrying on their

balance sheets. Many placed their firms on a hair trigger by relying heavily on short

term financing in repo and commercial paper markets for their day-to-day liquidity. They placed

solvency bets (sometimes unknowingly) that their housing investments were solid, and

liquidity bets that overnight money would always be available. Both turned out to be bad

bets. In several cases,failed solvency bets triggered liquidity crises, causing some of the

largest financial firms to fail or nearly fail. Firms were insufficiently transparent about their

housing risk, creating uncertainty in markets that made it difficult for some to access additional capital and liquidity when needed.

Risk Management

           The vulnerabilities associated with short-term wholesale funding can be seen as a structural weakness of the global financial system, they can also be viewed as a consequence of poor risk management by issuers and investors Unfortunately, the crisis revealed many other significant defects in private-sector risk management and risk controls. Examples included a significant deterioration of mortgage underwriting standards before the crisis, which was not limited to subprime borrowers; a similar weakening of underwriting standards for commercial real estate loans, together with poor management of concentration risk and other risks by commercial real estate lenders; excessive reliance by investors on credit ratings, especially in the case of structured credit products; and insufficient capacity by many large firms to track firm wide risk exposures, including off-balance-sheet exposures. Among other problems, risk-management weaknesses led to inadequate risk diversification by major financial firms, so that losses--rather than being dispersed broadly among investors--proved in some cases to be heavily concentrated, threatening the stability of the affected companies. Risk-management weaknesses were spread throughout the financial system, including at many institutions that were neither large nor too-big-to-fail. For example, problems with commercial real estate lending were concentrated in regional and community banks. Subprime lending was done by small as well as large firms.

Private-sector risk management also failed to keep up with financial innovation in many cases. An important example is the extension of the traditional originate-to-distribute business model to encompass increasingly complex securitized credit products, with wholesale market funding playing a key role. In general, the originate-to-distribute model breaks down the process of credit extension into components or stages--from origination to financing and to the post-financing monitoring of the borrower's ability to repay--in a manner reminiscent of how contemporary manufacturers distribute the stages of production across firms and locations. This general approach has been used in various forms for many years and can produce significant benefits, including lower credit costs and increased access of small and medium-sized borrowers to the broader capital markets. However, the expanded use of this model to finance subprime mortgages through securitization was mismanaged at several points, including the initial underwriting, which deteriorated markedly in part because of incentive schemes that effectively rewarded originators for the quantity rather than the quality of the mortgages extended. Loans were then packaged into securities that proved complex and unwieldy; for example, when defaults became widespread, the legal agreements underlying the securitizations made reasonable modifications of troubled mortgages difficult. Rating agencies' ratings of asset-backed securities were revealed to be subject to conflicts of interest and faulty models. At the end of the chain were investors that often relied mainly on ratings. Even if the end-investors wanted to do their own credit analysis, the information needed to do so was often difficult or impossible to obtain.

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