Financial Crisis Effects on the Global Economic Governance

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Introduction

Global financial markets had been on an upward tail spin from early parts of 2003-2004 following recovery from dot-com melt down in 2000-2001. This upward spiral began to show cracks in early 2007 and became worse in 2008 despite the efforts of central banks and regulators to restore growing concerns. The crisis stemmed from deterioration in credit quality of the banking system in the United States which was exacerbated by liquidity crunch. The result as we all know is downfall of many large financial institutions. The government had to intervene and bail out these institutions. It also led to downfall of stock markets across the world. (Shah, 2009)

What happened?
- Sub-prime mortgage crisis: The term subprime lending is the term used for lending to those borrowers who are subprime or who are not the first choice of financial institutes to provide loan. Such creditors may have a weak credit history or they could have defaulted on some payment. Subprime mortgages are instruments designed for borrowers who want the loan for a short term. These borrowers would either sell off the property early or increase their income so as to repay the amount soon enough. But the subprime mortgage was misused by property investors to finance their investment homes (Conerly, 2008)
- Excessive Leverage: According to Plunkett Research, Investment banks were overextended, operating with very high leverage. Typically, they were holding assets of about 30 times their total level of capital. That means that they were borrowing heavily, at a rate of about $97 for every $3 of capital (Plunkett Research, n.d.). Lehman Brothers and others of the like got the business opportunity in buying in mortgages to securitize them and sell them further in the market. When banks ran out of options for loaning these securities, they turned to loan it to the subprime, thus creating riskier portfolio for themselves. But they didn't realize it as property prices were soaring high, and subprime loans became popular in the US.
- Financial Engineering: Wall Street bankers used financial engineering to come up with high risk leveraged assets that artificially bloated their perceived wallet size and market capitalization.
Typical asset creation was done by Wall Street investment banks purchasing mortgages from the banks, thus freeing up banks' funds to lend more and providing investment banks an underlying asset to sell to clients. Such assets were used by investment banks to create derivative instruments. The banks then sold these instruments to varied institutional investors in different parts of the world. According to the Economictimes, "the key underlying risk point was that the instruments were to be redeemed as and when mortgage payments were received from borrowers, thus creating a dependence on mortgage payment receipt as a precursor to asset success. In all there was approximately US$ 1 trillion invested in these securities" (Ganesh, 2008).

How did it happen?
For many years before the subprime crisis started, real estate proved as a lucrative investment option to many. The rate of growth in the real estate was the fastest as compared to any other investment option. In fact, the real estate was growing at a rate from 7-8%. During late 1990s to mid 2000s, the real estate boom lead to a major increase in construction related jobs in the United States (Reavis, 2009).
From figure below, we can see that subprime mortgages grew from $173 billion in 2001 to a record level of $665 billion in 2005, which is an increase of nearly 300% (Petroff, n.d.).

The mayhem started as a primarily mortgage crisis, originating from huge exposures of over leveraged financial entities to the real estate sector. Real estate was considered the safest investment. According to Informations économie, "between 1997 and 2006, the price of the typical American house increased ...