What is Financial Crisis?

ASSIGNMENT 1

ACCOUNTING FOR MANAGEMENT

Submitted To:

Mr. Gurdeepak Singh

Submitted By:

Pratibah Pathak

MBA-I^st

What is Financial Crisis?

It is a situation in which the supply of money is outpaced by the demand for money. This means that liquidity evaporates quickly because available money is withdrawn from banks (called a run), forcing banks either to sell other investments to make up for the shortfall or to collapse.
The global financial crisis of 2008-2009 emerged in September 2008 with the failure & merger of several large U.S.-based financial institutions such as investment banks, insurance firms, and mortgage banks consequent to the subprime mortgage crisis, and spread with the insolvency of additional companies, and of governments in Europe.

This leads to recession and declining stock market prices around the globe.

Investopedia Says:

A financial crisis can come as a result of institutions or assets being overvalued, and can be exacerbated by investor behaviour. A rapid string of sell offs can further result in lower asset prices or more savings withdrawals. If left unchecked, the crisis can cause the economy to go into a recession or depression.

What are the causes of Financial Crisis?

The financial crisis was caused by the sudden drop in home prices. Banks held mortgages on homes that people could no longer pay. Normally, the bank forecloses on the home and sells it for either profit or break-even. But this time, home values had fallen by as much as 40%. So banks lost 40% of their original investment when people started falling behind on mortgages payments and the banks were forced to foreclose.

This is easier to describe with numbers. Say a bank gives a family a mortgage for the total value of their home, say $100,000 (this is lower than most mortgages, but makes it easier to see what's going on). The home then loses 40% of its market value, becoming worth only $60,000. The family then falls behind on their mortgages payments and the bank has to foreclose. The bank can only recover that $60,000 and is out $40,000. Now imagine this happening millions of times.

Once you get into much more complex financial mechanisms, we find that banks packaged these loans as investments call CDOs (collateralize debt obligations) that they then sold to other banks or financial institutions. Sometimes they are called commercial paper. When the value of these assets plummeted, a lot of financial institutions lost a lot of money. Again, normally this really has no bearing. But some bad choices were made with a normally useful financial tool called leverage. One can leverage funds by (this is a simple description) using the cash you have on hand as a down payment on a loan and then taking that loan an investing it.

A great example of this is taking $100,000 and instead of buying just one house that you rent out to someone, you take out mortgages on 10 houses and use the $100,000 has a down payment. You now own ten houses that you can collect rent from.

How Financial Crisis can be prevented?

Ø The crisis is a lack of trust among banks. The first step would have to be a total transparency of large interbank loans, similar to stocks. Since banks don't like this, only government can order disclosure of essential loan data. Pouring money into the system does not solve the problem. There is enough liquidity; it is just not being used.

Ø Get liquidity back into the markets: Banks are still strapped for cash and we are starting to witness a decline in lending. This causes businesses to have to cut back. This is why we are now seeing an increasing unemployment rate.

Ø Consumer confidence: If people have a belief in future success they will invest their time, energy and capital in ways that will restore the economy to a growth path. Confidence has been undermined in many ways over the last two decades. One of the greatest problems has been the lack of investment in manufacturing in this country. The result has been a loss of what the politicians term "good jobs". So confidence in consumer should always be there.

Ø Tax cuts: Further reduce individual and corporate tax rates across the board and announce that there will be no tax increases for at least two years. Do this at both the Federal and state levels. This will increase the confidence of individuals and businesses will increase trade, investment, business growth, and hiring. As businesses and individuals all become more successful, even low tax rates applied to a higher volume of trade will actually bring in more income to governments, not less.