Q1.How can financial innovations lead to financial crisis?
Explain specifically the role of securitization of the mortgage
market.Financial crises are considered to be a major disruption in
the financial markets. Financial crises often results in sharp
declines in the prices of the assets and also leads towards
failures of many financial and non-financial organizations. When we
talk about financial innovation we often refer to the advancements
and emergence of new techniques that take place in the financial
market. Study suggests that financial liberalization often leads
towards financial innovation and thus creates an environment that
is less controlled by restrictions. This elimination of
restrictions also means lower level of monitoring on investments
taking place in a financial market. This also means that the
financial intermediaries and other parties are now in a position
where they can take drastic steps to get hold of the major chunk of
the investments available in the market. Though innovation in
financial markets is considered to be a positive thing but studies
suggest that certain innovations have resulted in emergence of
complex financial instruments and issues like adverse selection and
moral hazard problems. These complex financial instruments have led
towards credit expansion which has resulted in financial crises.
Securitization is one of the processes that also emerged due to the
innovation in the financial markets. In simple terms it is the
process of creating securities by pooling together various
cash-flow producing financial assets. Securitization is termed by
many as the main cause of the recent financial crises that hit U.S.
Securitization in the mortgage markets unrestricted by any
government regulations motivated the banks and other involved
intermediaries to make riskier investments and to use the
securities for earning more and more. This all landed them
ultimately in a situation where they were unable to recover the
loans. The crises that was actually built by financial innovation
like securitization was actually a result of an ineffective role
played by the government, the rating and other monitoring agencies
and most importantly by the investment banks and other
intermediaries. All of these parties failed to realize the downside
of the actions that were taking place in the name of greater
financial liberalization and the ultimate result was the bust in
the housing market and the downfall of the financial market.Q.2.How
were adverse selection and moral hazard contributing factors in
this crisis?In case of the recent financial crisis, moral hazard
and adverse selection issues raised due to various factors that
lead towards poor investment decisions and thus resulting in a
financial crisis. One of the reasons for possibilities of adverse
selection and moral hazard was the conflicting role played by the
rating agencies that made them to issue good ratings even when the
reality was otherwise. These rating agencies apart from playing the
role of credit rating also advised financial intermediaries on
making financial decisions. This all encouraged them to issue
misleading ratings and thus was the cause of wrong financial
decisions made by investing entities. Similarly greater
liberalization of the financial markets also meant that the
government was not keeping its close check on the activities of the
financial market and this all also allowed the intermediaries and
financial institutions to issue misleading information that often
resulted in adverse selection and moral hazard problem. However the
real reason that leads to adverse selection and moral hazard
problems was the practices and new investment techniques that
involved a third party investment situation. In such situations
banks opted to go for riskier investments while at the same time
introduced practices like securitization. This created a situation
where lenders and investors were less aware about the borrowers and
this lack of awareness or lack of information lead to the situation
what possibly caused the problems of adverse selection and moral
hazards.Q.3.Did the unprecedented level of government intervention
in the economy prevent an even more severe economic downturn than
what actually occurred? Is this affecting a moral hazard problem in
the future?In order to counter the effects of great recession the
government took drastic steps and many are of the view that this
government intervention avoided what could have been a more severe
economic downturn. The U.S. government took steps to expand the
money supplies and to avoid the risk of deflationary spiral.
Further the U.S. Federal Reserves revised liquidity facilities
allowed the central bank to fulfil its lender of last resort role
in a more effective way and similarly largest liquidity injection
into the credit market in the history was introduced during this
time. Similarly government took various other steps that allowed it
to control the effects of financial crisis. However there is a
counterargument to this intervention of the government. Few
analysts are of the view that the involvement of the government
allows the financial market entities to take riskier investments as
they know that government will be there to save them if they land
themselves in a situation of crisis. This often results in careless
investment decisions and can thus result in a situation of moral
hazard. Therefore it is advised that government should enter only
when there is no other solution for survival and in other cases the
government should work for avoiding any possibilities that can lead
towards a situation of crisis.
Q.4.What will be the long-term impact of the governments
intervention, particularly the ballooning of the national debt?The
intervention by the government has resulted in lowering the impact
of the financial crisis on the economy of the country. This will
allow the U.S. economy to return to its normal position in due
course of time. However one aspect of this intervention can be that
the intermediaries and the parties involved can continue to invest
in riskier investments with a belief of getting saved by the
government unless stricter checks and regulations are not
introduced. However the real negative impact that has already been
exposed and is expected to make negative impact on the economy is
the ballooning of the national debt. The injecting of greater money
supplies by the government has been done at the cost of incurring
greater debts on the country this means that today the debt on the
U.S. government has increased into several trillions of dollars
partially due to the preventive measures that it took to counter
the impact of the financial crisis. If this situation is not
controlled, than this can result in another financial turmoil for
the economy.
