Financial Crisis Case Study
3. Explain what the leverage effect consists of, relating it to the credit risk market development previous the crisis (see Exhibit 1 in “The financial crisis of 2007-2009: the road to systemic risk”)
Leverage is the process of obtaining money with loans or financial instruments. This debt may be used to acquire assets or develop a project, financing its CAPEX and being payed later with the respective cashflows. And that is the point where risk enters: if the expected cashflows happen to be below the minimum necessary to hold the trust that the debt will be payed, a default possibility is considered, leading to liquidity problems and losses.
In the financial markets, return rates have an important role, being the responsible for assuring the expected returns. If the rates can’t …show more content…
What should both companies and regulators do in order to prevent future crises in the financial sector as the ones experienced in 2007-2008? Provide your opinion
It is evident, from what has been described here, that the financial crisis is due to different internal and external factors. The lack of responsibility of the top management and the board of directors, the "leverage ratio" out of control, the clear imbalance in short-term debt and risk management that is not appropriate to the real estate sector can be accounted for as internal determinants. The problem in the real estate sector is that, as we already commented, it saw a big collapse after a constant increase of the houses’ prices and the demand of them, supported by the government that contributed to strengthen the so called “American Dream”; the inconsistency of the rating agencies, that, instead of providing to the investors reliable information about the real riskiness of various securities, gave them unrealistic positive ratings and not reliable evaluations of the solvency of financial institutions; and the behavior of the Fed, SEC and ultimately JP Morgan are the main causes of the biggest failure in US
Leverage is the process of obtaining money with loans or financial instruments. This debt may be used to acquire assets or develop a project, financing its CAPEX and being payed later with the respective cashflows. And that is the point where risk enters: if the expected cashflows happen to be below the minimum necessary to hold the trust that the debt will be payed, a default possibility is considered, leading to liquidity problems and losses.
In the financial markets, return rates have an important role, being the responsible for assuring the expected returns. If the rates can’t …show more content…
What should both companies and regulators do in order to prevent future crises in the financial sector as the ones experienced in 2007-2008? Provide your opinion
It is evident, from what has been described here, that the financial crisis is due to different internal and external factors. The lack of responsibility of the top management and the board of directors, the "leverage ratio" out of control, the clear imbalance in short-term debt and risk management that is not appropriate to the real estate sector can be accounted for as internal determinants. The problem in the real estate sector is that, as we already commented, it saw a big collapse after a constant increase of the houses’ prices and the demand of them, supported by the government that contributed to strengthen the so called “American Dream”; the inconsistency of the rating agencies, that, instead of providing to the investors reliable information about the real riskiness of various securities, gave them unrealistic positive ratings and not reliable evaluations of the solvency of financial institutions; and the behavior of the Fed, SEC and ultimately JP Morgan are the main causes of the biggest failure in US