Ocaya (2012) state that credit crisis is a financial market or economic meltdown of lending the funds to the borrower and cannot get back, it evaluated by severe shortage of money or credit bring accumulation of bad debts, defaults and falling financial institutions among others. However, the experts and economists is unclear as what form a credit crisis. The Wall Street defines a credit crisis as a “period during which borrowed funds are difficult to get and, even if funds can found, interest rates are very high”.
Credit crisis mostly began in 2007. The effect of credit crisis has brought fall down on housing market in some country resulting in foreclosures and unemployment. In addition, the credit crisis had an immediate effects on property markets but has spread into global trade and has affected the overall prediction global economy growth , forcing growth target of many countries changing down. While they are some countries had not severely affected by credit crisis.
This critical discuss or analysis involve a title of bank CEO incentives were a major causes in credit crisis that links to the journal of “Bank CEO incentives and the credit crisis”, written by Rudiger Fahlenbrach and Rene M. Stulz and other journal as well.
Fahlenbrach and Stulz (2011) stated that investigation of explanations for the dramatic collapse of the equity capital of much of the banking industry in the U.S, one highlight argument is that bank executive has poor incentives during the credit crisis. They decide how closely the interests of the bank CEO aligned with those of their shareholders before the start of the crisis, whether this can explain performance of banks in the cross-section during the credit crisis and how bank CEO do during the crisis. Besides that, corporate governance specialist and economic profession find that since Adam Smith have considered interest of management are better aligned with those of their shareholders when compensation of managers increases when shareholders gain and fall when shareholders lose. Micheal, Rao and William (2006) suggests that an executive's holdings of stock options could play a significant role in aligning shareholder interests with managerial incentives.
On average, bank CEO had powerful incentives to maximize shareholder wealth by 2006. They show that in their sample the median value of a CEOs equity stake., which taking into account options was $36 million. Generally, equity stake of bank CEO was worth more than ten times his compensation in 2006.
The results show that there is no evidence prove that banks led by CEO whose interests better alignment with those of their shareholders had higher stock returns during the crisis and some evidence show that banks with better aligned of CEO interest with those of their shareholders had a worse return on equity and stock returns. Specifically, whether the sample includes investment banks or not, stock return and accounting equity return performance are negatively related to bank CEOs dollar incentives, measured as the dollar change in a CEOs wealth for a 1% change in the stock price. This effect is clear and is not explained by a few banks where CEOs had extremely high ownership. An increase of one standard deviation in dollar ownership associated with lower returns of 10.2%. Similarly, a bank’s return on equity in 2008 is negatively related to its CEO’s holdings of shares in 2006 – a one standard deviation increase in dollar ownership associated with about a 10.1% lower return on equity. Though options have blamed for leading to excessive risk-taking, there is no evidence in our sample that greater sensitivity of CEO pay to stock volatility led to worse stock returns during the credit crisis. Further, option compensation did not have influence on bank performance during the crisis.
A plausible explanation for these findings is that CEOs focused on the interests of their shareholders in the build-up to the crisis and took actions that they believed the market would welcome. Ex post, these actions were costly to their banks and to themselves when they produced poor results. These poor results were not expected by the CEOs to the extent that they did not cut their holdings of shares anticipation of the crisis or during the crisis. Furthermore, there is no evidence that they hedged their equity exposure. Consequently, they suffered extremely large wealth losses as a result of the crisis because they typically did not sell shares.
This shows that bank CEOs had very high incentives to maximize shareholder wealth. This evidence makes it implausible that the credit crisis can blamed on misalignment of incentives between CEOs and shareholders. While misaligned incentives play a dominant role in the minds of economists, it has appealed as this narrative might be in explaining the financial crisis of 2007 - 2008 ,which best it was a supportive not primary.
When the bank CEOs and non-bank CEOs compared, bank CEOs receive less salary, fewer stock options and have a smaller part of their total pay coming from stock options and stock holdings. These results contradict the idea that compensation packages in the banking industry offer incentives for risk taking (Micheal, Walter and Williams, 2008).
On the one hand, the role of incentives perceived to play a crucial if not the major causal role. Besides that, there is many causes in credit crisis. Though overall bank performance from July 2007 to December 2008 was the worst since the Great Depression, there is significant variation in the cross-section of stock returns of large banks across the world during that period (Beltratti & Stulz, 2012).
Since the US sub-prime problems , one major US institution – Lehman Brothers – has gone bankrupt, and other key mortgage providers in both the USA (Fannie Mae and Freddie Mac) and UK (Northern Rock and Bradford and Bingley) have become dependent upon central government support for their survival.
According to Brunnermeier (2009) stated that as the price index declines, the cost of insuring a basket of mortgages of a certain rating against default increases. Investor in subprime mortgage-backed securities would have demanded higher returns and greater capital cushions. Which resulted borrowers would not have found credit as cheap or as easy to get as it became during subprime credit boom.Subprime borrowers typically have weakened credit histories and reduced repayment capacity. Subprime loans have a higher risk of default than loans to prime borrowers. If a borrower is delinquent in making timely mortgage payments to the loan servicers (a bank or other financial firm), the lender may take possession of the property, in a process called foreclosure. Consumer spending is down, the housing market has plummeted, foreclosure numbers continue to rise and the stock market has shaken. The subprime crisis and resulting foreclosure fallout has caused dissension among consumers, lenders and legislators and spawned furious debate over the causes and possible fixes of the “mess.”
There is several reason what led to mortgage. Many experts and economics profession believe it came about though combination of a several factors in which subprime lending played a major part and resulted in credit crisis.
Holt (2009) stated that the general consensus is that the primary cause of the current recession was the credit crisis arising from the bursting of the housing bubble. Numerous commentators have weighed in on the causes of the housing bubble and the resulting credit crisis. A housing bubble is an economic bubble that occurs in local or global real estate markets. It defined by rapid increases in the valuations of real property until unsustainable levels reached with incomes and other indicators of affordability. Following the rapid increases are decreases in home prices and mortgage debt that is higher than the value of the property.
Many economists believe that the U.S. housing bubble caused in part by historically low-interest rates. Low interest rates and large inflows of foreign funds created easy credit conditions for a several years before the crisis, fueling a housing market boom and encouraging debt-financed consumption. Subprime lending was a major contributor to this increase in home ownership rates and in the overall demand for housing, which drove prices higher. Speculative borrowing in residential real estate has cited as a contributing reason to the subprime mortgage crisis. In answer to a question about the causes of the subprime crisis, Greenspan said that it was more an issue of house prices than mortgage credit.
Johnson and Neave (2008) state that essentially, we attribute the difficulties in the subprime market to an evolving mismatch between loan quality, as measured by default risk, and the loans' governance as measured by the joint risk control capabilities of lenders and investors. The difficulties have compounded by the use of collateral debt obligations (CDOs) with varying exposure to the default risks and the further use of default insurance.
Default insurance on the mortgage portfolio meant that neither the original lenders nor institutional investors faced strong incentives to check the default risks. At the same time, some insurers eager for business under-priced the default insurance they sold.
Dowd , et al., (2009) comments that the key reason in the credit is liquidity in the market for sub-prime mortgage based CMOs due to increasing uncertainty about the value of the underlying collateral. The value of a bond purchased from a CDO or CMO is usually model based, and dependent upon a set of assumptions about the risk of the underlying collateral, but such assumptions are both subjective and uncertain. Most importantly, the perceived risk at the time of buying of such bonds may change over time, leading to a change in their value.
Finally, I am disagree with bank CEO incentives were a major causes in credit crisis. Since, it is entirely fair to argue that these tests are not decisive. But still, the evidence is not there, at least not yet, that bank CEO incentives were a major reason in credit crisis. As I already find some journal and other evidence to prove that, what I end there will be many causes combine together and result in credit crisis. I find that bank CEO incentive were only one of the causes in credit crisis. Because there is no any journal or evidence to prove it is a major reason and I find that the rises in credit crisis which combination of other causes.
