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Economic crisis of 2008:

The global financial crisis, brewing for a while, really started to show its effects in the middle of
2008. Around the world stock markets have fallen, large financial institutions have collapsed or
been bought out, and governments in even the wealthiest nations have had to come up with
rescue packages to bail out their financial systems.
On the one hand many people are concerned that those responsible for the financial problems are
the ones being bailed out, while on the other hand, a global financial meltdown will affect the
livelihoods of almost everyone in an increasingly inter-connected world. In 2008, a global
economic crisis was suggested by several important indicators of economic downturn
worldwide. These included high oil prices, which led to both high food prices (due to a
dependence of food production on petroleum, as well as using food crop products (ethanol,
biodiesel) as an alternative to petroleum) and global inflation; a substantial credit crisis leading
to the bankruptcy of large and well established investment banks as well as commercial banks in
various nations around the world; increased unemployment; and the possibility of a global
recession.
During the last several months we have witnessed one of the most trying times for financial
markets in several decades, perhaps since the 1930s Great Depression. The litany of events that
have led up to the present. As you all well know, the originators of lower quality mortgages in
the United States had strong incentives to meet a constant and, indeed, increasing demand for
securitized products of some form or another. There was little incentive to originate good loans
or monitor the borrowers creditworthiness. Additionally, the high demand for other types of
structured credit products, such as those formed from commercial real estate, leveraged loans,
and some other types of consumer credit, meant that these sectors also witnessed weakened
credit standards. In these categories, the after-effects are just now becoming visible.
Global trends
High commodity prices
Further information: 2000s energy crisis and 20072008 world food price crisis
See also: 2008 Central Asia energy crisis and 2008 Bulgarian energy crisis
Medium term crude oil prices, (not adjusted for inflation)
The decade of the 2000s saw a 2008 commodities boom, in which the prices of primary
commodities rose again after the Great Commodities Depression of 1980-2000. But in 2008, the
prices of many commodities, notably oil and food, rose so high as to cause genuine economic
damage, threatening stagflation and a reversal of globalization.
In January 2008, oil prices surpassed $100 a barrel for the first time, the first of many price
milestones to be passed in the course of the year.
[2]
By July the price of oil reached as high as
$147 a barrel although prices fell soon after.
The food and fuel crises were both discussed at the 34th G8 summit in July.
Sulfuric acid (an important chemical commodity used in processes such as steel processing,
copper production and bioethanol production) increased in price 6-fold in less than 1 year whilst
producers of sodium hydroxide have declared force major due to flooding, precipitating similarly
steep price increases.
In the second half of 2008, the prices of most commodities fell dramatically on expectations of
diminished demand in a world recession.
Trade
In mid-October 2008, the Baltic Dry Index, a measure of shipping volume, fell by 50% in one
week, as the credit crunch made it difficult for exporters to obtain letters of credit.
Inflation
In February 2008, Reuters reported that global inflation was at historic levels, and that domestic
inflation was at 10-20 year highs for many nations. Excess money supply around the globe,
monetary easing by the Fed to tame financial crisis, growth surge supported by easy monetary
policy in Asia, speculation in commodities, agricultural failure, rising cost of imports from China
and rising demand of food and commodities in the fast growing emerging markets, have been
named as possible reasons for the inflation.
In mid-2008, IMF data indicated that inflation was highest in the oil-exporting countries, largely
due to the unsterilized growth of foreign exchange reserves, the term unsterilized referring to a
lack of monetary policy operations that could offset such a foreign exchange intervention in
order to maintain a countrys monetary policy target. However, inflation was also growing in
countries classified by the IMF as non-oil-exporting LDCs (Least Developed Countries) and
Developing Asia, on account of the rise in oil and food prices.
Inflation was also increasing in the developed countries, but remained low compared to the
developing world.
Unemployment
The International Labour Organization predicted that at least 20 million jobs will have been lost
by the end of 2009 due to the crisis mostly in construction, real estate, financial services, and
the auto sector bringing world unemployment above 200 million for the first time.
Return of volatility
For a time, major economies of the 21st century were believed to have begun a period of
decreased volatility, which was sometimes dubbed The Great Moderation, because many
economic variables appeared to have achieved relative stability. The return of commodity, stock
market, and currency value volatility are regarded as indications that the concepts behind the
Great Moderation were misguided by false beliefs
Financial markets
January 2008 stock market volatility
January 2008 was an especially volatile month in world stock markets, with a surge in implied
volatility measurements of the US-based S&P 500 index and a sharp decrease in non-U.S. stock
market prices on Monday, January 21, 2008 (continuing to a lesser extent in some markets on
January 22). Some headline writers and a general news columnist called January 21 Black
Monday and referred to a global shares crash, though the effects were quite different in
different markets.
American stock markets were closed on Monday, January 21 for Martin Luther King, Jr. Day.
Seemingly in response to the fall in non-U.S. markets, the U.S. Federal Reserve announced a
surprise rate cut of 0.75% on Tuesday at 8 a.m. This rate cut is believed to have been influential
in preventing large declines in the American stock markets, with the Dow Jones Industrial
Average down only 1.1% for the day, never closing that week worse than a 1.6% decrease from
the previous Friday, and indeed closed up for the week. Later it was announced that Socit
Gnrale, one of the largest banks in Europe, accused its employee Jrme Kerviel of fraudulent
trades costing it 4.9 billion, and causing it to sell approximately 50 billion in European equity
derivatives from January 2123.
The effects of these events were also felt on the Shanghai Composite Index in China which lost
5.14 percent, most of this on financial stocks such as Ping An Insurance and China Life which
lost 10 and 8.76 percent respectively. Investors worried about the effect of a recession in the US
economy would have on the Chinese economy. Citigroup estimates due to the number of exports
from China to America a one percent drop in US economic growth would lead to a 1.3 percent
drop in Chinas growth rate.
Market downturn Fall 2008
Main article: Global financial crisis of 2008
As of October 2008, stocks in North America, Europe, and the Asia-Pacific region had all fallen
by about 30% since the beginning of the year. The Dow Jones Industrial Average had fallen
about 37% since January 2008.
There were several large Monday declines in stock markets world wide during 2008, including
one in January, one in August, one in September, and another in early October.
The simultaneous multiple crises affecting the US financial system in mid-September 2008
caused large falls in markets both in the US and elsewhere. Numerous indicators of risk and of
investor fear (the TED spread, Treasury yields, and the dollar value of gold) set records.
Russian markets, already falling due to declining oil prices and political tensions with the West,
fell over 10% in one day, leading to a suspension of trading, while other emerging markets also
exhibited losses.
On September 18, UK regulators announced a temporary ban on short-selling of financial stocks.
On September 19 the United States SEC followed by placing a temporary ban of short-selling
stocks of 799 specific financial institutions. In addition, the SEC made it easier for institutions to
buy back shares of their institutions. The action is based on the view that short selling in a crisis
market undermines confidence in financial institutions and erodes their stability.
On September 22, the Australian Securities Exchange (ASX) delayed opening by an hour
[141]

after a decision was made by the Australian Securities and Investments Commission (ASIC) to
ban all short selling on the ASX. This was revised slightly a few days later.
Subprime mortgage crisis
The subprime mortgage crisis is an ongoing financial crisis triggered by a significant decline in
housing prices and related mortgage payment delinquencies and foreclosures in the United
States. This caused a ripple effect across the financial markets and global banking systems, as
investments related to housing prices declined significantly in value, placing the health of key
financial institutions and government-sponsored enterprises at risk. Funds available for personal
and business spending (i.e., liquidity) declined as financial institutions tightened lending
practices. The crisis, which has roots in the closing years of the 20th century but has become
more apparent throughout 2007 and 2008, has passed through various stages exposing pervasive
weaknesses in the global financial system and regulatory framework.
The crisis began with the bursting of the United States housing bubble and high default rates on
subprime and adjustable rate mortgages (ARM), beginning in approximately 20052006.
Government policies and competitive pressures for several years prior to the crisis encouraged
higher risk lending practices. Further, an increase in loan incentives such as easy initial terms
and a long-term trend of rising housing prices had encouraged borrowers to assume difficult
mortgages in the belief they would be able to quickly refinance at more favorable terms.
However, once interest rates began to rise and housing prices started to drop moderately in
20062007 in many parts of the U.S., refinancing became more difficult. Defaults and
foreclosure activity increased dramatically as easy initial terms expired, home prices failed to go
up as anticipated, and ARM interest rates reset higher. Foreclosures accelerated in the United
States in late 2006 and triggered a global financial crisis through 2007 and 2008. During 2007,
nearly 1.3 million U.S. housing properties were subject to foreclosure activity, up 79% from
2006.
Financial products called mortgage-backed securities (MBS), which derive their value from
mortgage payments and housing prices, had enabled financial institutions and investors around
the world to invest in the U.S. housing market. Major Banks and financial institutions had
borrowed and invested heavily in MBS and reported losses of approximately US$435 billion as
of 17 July 2008. The liquidity and solvency concerns regarding key financial institutions drove
central banks to take action to provide funds to banks to encourage lending to worthy borrowers
and to restore faith in the commercial paper markets, which are integral to funding business
operations. Governments also bailed out key financial institutions, assuming significant
additional financial commitments.
The risks to the broader economy created by the housing market downturn and subsequent
financial market crisis were primary factors in several decisions by central banks around the
world to cut interest rates and governments to implement economic stimulus packages. These
actions were designed to stimulate economic growth and inspire confidence in the financial
markets. Effects on global stock markets due to the crisis have been dramatic. Between 1 January
and 11 October 2008, owners of stocks in U.S. corporations had suffered about $8 trillion in
losses, as their holdings declined in value from $20 trillion to $12 trillion. Losses in other
countries have averaged about 40%. Losses in the stock markets and housing value declines
place further downward pressure on consumer spending, a key economic engine. Leaders of the
larger developed and emerging nations met in November 2008 to formulate strategies for
addressing the crisis.
Background:
Subprime lending is the practice of lending, mainly in the form of mortgages for the purchase of
residences, to borrowers who do not meet the usual criteria for borrowing at the lowest
prevailing market interest rate. These criteria pertain to the down payment and the borrowing
households income level, both as a fraction of the amount borrowed, and to the borrowing
households employment status and credit history. If a homeowner is delinquent in making
payments to the bank (or other holder of the mortgage loan), that entity can seize the home in a
process called foreclosure.
The value of USA subprime mortgages was estimated at $1.3 trillion as of March 2007, with
over 7.5 million first-lien subprime mortgages outstanding.
[
In the third quarter of 2007, subprime
ARMs making up only 6.8% of USA mortgages outstanding also accounted for 43% of the
foreclosures begun during that quarter.
[
By October 2007, approximately 16% of subprime
adjustable rate mortgages (ARM) were either 90-days delinquent or the lender had begun
foreclosure proceedings, roughly triple the rate of 2005.
[
By January 2008, the delinquency rate
had risen to 21%
[
and by May 2008 it was 25%.
The value of all outstanding USA mortgages, owed by households to purchase residences
housing at most 4 families, was US$9.9 trillion as of yearend 2006, and US$10.6 trillion as of
midyear 2008.
[
During 2007, lenders had begun foreclosure proceedings on nearly 1.3 million
properties, a 79% increase over 2006.
[
As of August 2008, 9.2% of all mortgages outstanding
were either delinquent or in foreclosure.
[
936,439 USA residences completed foreclosure between
August 2007 and October 2008.
Understanding credit risk:
Credit risk arises because a borrower has the option of defaulting on the loan he owes.
Traditionally, lenders (who were primarily thrifts) bore the credit risk on the mortgages they
issued. Over the past 60 years, a variety of financial innovations have gradually made it possible
for lenders to sell the right to receive the payments on the mortgages they issue, through a
process called securitization. The resulting securities are called mortgage backed securities
(MBS) and collateralized debt obligations (CDO). Most American mortgages are now held by
mortgage pools, the generic term for MBS and CDOs. Of the $10.6 trillion of USA residential
mortgages outstanding as of midyear 2008, $6.6 trillion were held by mortgage pools and $3.4
trillion by traditional depository institutions.
This originate to distribute model means that investors holding MBS and CDOs also bear
several types of risks, and this has a variety of consequences. There are four primary types of
risk: credit risk on the underlying mortgages, asset price risk, liquidity risk, and counterparty
risk. When homeowners default, the payments received by MBS and CDO investors decline and
the perceived credit risk rises. This has had a significant adverse effect on investors and the
entire mortgage industry. The effect is magnified by the high debt levels (financial leverage)
households and businesses have incurred in recent years. Finally, the risks associated with
American mortgage lending have global impacts, because a major consequence of MBS and
CDOs is a closer integration of the USA housing and mortgage markets with global financial
markets.
Investors in MBS and CDOs can insure against credit risk by buying Credit defaults swaps
(CDS). As mortgage defaults rose, the likelihood that the issuers of CDS would have to pay their
counterparties increased. This created uncertainty across the system, as investors wondered if
CDS issuers would honor their commitments.
Causes of Financial crisis:
The reasons for this crisis are varied and complex. The crisis can be attributed to a number of
factors pervasive in both the housing and credit markets, which developed over an extended
period of time. There are many different views on the causes, including the inability of
homeowners to make their mortgage payments, poor judgment by the borrower and/or the
lender, speculation and overbuilding during the boom period, risky mortgage products, high
personal and corporate debt levels, complex financial innovations that distributed and perhaps
concealed default risks, central bank policies, and government regulation (or alternatively lack
thereof). In its 15 November 2008 Declaration of the Summit on Financial Markets and the
World Economy, leaders of the Group of 20 cited the following causes:
During a period of strong global growth, growing capital flows, and prolonged stability earlier
this decade, market participants sought higher yields without an adequate appreciation of the
risks and failed to exercise proper due diligence. At the same time, weak underwriting standards,
unsound risk management practices, increasingly complex and opaque financial products, and
consequent excessive leverage combined to create vulnerabilities in the system. Policy-makers,
regulators and supervisors, in some advanced countries, did not adequately appreciate and
address the risks building up in financial markets, keep pace with financial innovation, or take
into account the systemic ramifications of domestic regulatory actions.
In its 15 November 2008 Declaration of the Summit on Financial Markets and the World
Economy, leaders of the Group of 20 cited the following causes:
Boom and bust in the housing market
United States housing bubble and United States housing market correction
Existing homes sales, inventory, and months supply, by quarter.
Common indexes used for adjustable rate mortgages (19962006).
Low interest rates and large inflows of foreign funds created easy credit conditions for many
years leading up to the crisis.
[
Subprime lending and borrowing was a major contributor to an
increase in home ownership rates and the demand for housing. The U.S. home ownership rate
increased from 64% in 1994 (about where it was since 1980) to a peak in 2004 with an all-time
high of 69.2%.
This demand helped fuel housing price increases and consumer spending. Between 1997 and
2006, American home prices increased by 124%. For the two decades until 2001, the national
median home price went up and down, but it remained between 2.9 and 3.1 times the median
household income. By 2004, however, the ratio of home prices to income hit 4.0, and by 2006
the ratio was 4.6.
[
Some homeowners used the increased property value experienced in the
housing bubble to refinance their homes with lower interest rates and take out second mortgages
against the added value to use the funds for consumer spending. U.S. household debt as a
percentage of income rose to 130% during 2007, versus 100% earlier in the decade. A culture of
consumerism is a factor in an economy based on immediate gratification. Americans spent
$800 billion per year more than they earned. Household debt grew from $680 billion in 1974 to
$14 trillion in 2008, with the total doubling since 2001. During 2008, the average U.S. household
owned 13 credit cards, and 40 percent of them carried a balance, up from 6 percent in 1970.
Overbuilding during the boom period eventually led to a surplus inventory of homes, causing
home prices to decline, beginning in the summer of 2006. Easy credit, combined with the
assumption that housing prices would continue to appreciate, had encouraged many subprime
borrowers to obtain adjustable-rate mortgages they could not afford after the initial incentive
period. Once housing prices started depreciating moderately in many parts of the U.S.,
refinancing became more difficult. Some homeowners were unable to re-finance and began to
default on loans as their loans reset to higher interest rates and payment amounts.
An estimated 8.8 million homeowners nearly 10.8% of total homeowners had zero or
negative equity as of March 2008, meaning their homes are worth less than their mortgage. This
provided an incentive to walk away from the home, despite the credit rating impact. In the
U.S., home mortgages are non-recourse loans, meaning the creditor cannot seize other property
or income to cover a default. The U.S. is virtually unique in such arrangements. By November
2008, 12 million homeowners had negative equity. As more homeowners stop paying their
mortgages, foreclosures and the supply of homes increase. This places downward pressure on
housing prices, which places more homeowners upside down, continuing the cycle. The
declining mortgage payments also reduce the value of mortgage-backed securities, eating away
at the financial health of banks. This vicious cycle is at the heart of the crisis.
Increasing foreclosure rates increased the supply of housing inventory available. Sales volume
(units) of new homes dropped by 26.4% in 2007 versus the prior year. By January 2008, the
inventory of unsold new homes stood at 9.8 months based on December 2007 sales volume, the
highest level since 1981. Further, a record of nearly four million unsold existing homes were for
sale,
[
including nearly 2.9 million that were vacant.
This excess supply of home inventory placed significant downward pressure on prices. As prices
declined, more homeowners were at risk of default and foreclosure. According to the S&P/Case-
Shiller price index, by November 2007, average U.S. housing prices had fallen approximately
8% from their Q2 2006 peak and by May 2008 they had fallen 18.4%. The price decline in
December 2007 versus the year-ago period was 10.4% and for May 2008 it was 15.8%.Housing
prices are expected to continue declining until this inventory of surplus homes (excess supply) is
reduced to more typical levels.
Speculation
Speculation in real estate was a contributing factor. During 2006, 22% of homes purchased (1.65
million units) were for investment purposes, with an additional 14% (1.07 million units)
purchased as vacation homes. During 2005, these figures were 28% and 12%, respectively. In
other words, nearly 40% of home purchases (record levels) were not primary residences. NARs
chief economist at the time, David Lereah, stated that the fall in investment buying was expected
in 2006. Speculators left the market in 2006, which caused investment sales to fall much faster
than the primary market.
While homes had not traditionally been treated as investments like stocks, this behavior changed
during the housing boom. For example, one company estimated that as many as 85% of
condominium properties purchased in Miami were for investment purposes. Media widely
reported the behavior of purchasing condominiums prior to completion, then flipping (selling)
them for a profit without ever living in the home. Some mortgage companies identified risks
inherent in this activity as early as 2005, after identifying investors assuming highly leveraged
positions in multiple properties.
Keynesian economist Hyman Minsky described three types of speculative borrowing that can
contribute to the accumulation of debt that eventually leads to a collapse of asset values: the
hedge borrower who borrows with the intent of making debt payments from cash flows from
other investments; the speculative borrower who borrows based on the belief that they can
service interest on the loan but who must continually roll over the principal into new
investments; and the Ponzi borrower (named for Charles Ponzi), who relies on the appreciation
of the value of their assets (e.g. real estate) to refinance or pay-off their debt but cannot repay the
original loan.
The role of speculative borrowing has been cited as a contributing factor to the subprime
mortgage crisis.
High-risk mortgage loans and lending practices:
A variety of factors have caused lenders to offer an increasing array of higher-risk loans to
higher-risk borrowers, including illegal immigrants. The share of subprime mortgages to total
originations was 5% ($35 billion) in 1994, 9% in 1996, 13% ($160 billion) in 1999, and 20%
($600 billion) in 2006.A study by the Federal Reserve indicated that the average difference in
mortgage interest rates between subprime and prime mortgages (the subprime markup or risk
premium) declined from 2.8 percentage points (280 basis points) in 2001, to 1.3 percentage
points in 2007. In other words, the risk premium required by lenders to offer a subprime loan
declined. This occurred even though subprime borrower credit ratings and loan characteristics
declined overall during the 20012006 period, which should have had the opposite effect. The
combination is common to classic boom and bust credit cycles.
In addition to considering higher-risk borrowers, lenders have offered increasingly high-risk loan
options and incentives. These high risk loans included the No Income, No Job and no Assets
loans, sometimes referred to as Ninja loans. In 2005 the median down payment for first-time
home buyers was 2%, with 43% of those buyers making no down payment whatsoever.
Another example is the interest-only adjustable-rate mortgage (ARM), which allows the
homeowner to pay just the interest (not principal) during an initial period. Still another is a
payment option loan, in which the homeowner can pay a variable amount, but any interest not
paid is added to the principal. Further, an estimated one-third of ARM originated between 2004
and 2006 had teaser rates below 4%, which then increased significantly after some initial
period, as much as doubling the monthly payment.
Mortgage underwriting practices have also been criticized, including automated loan approvals
that critics argued were not subjected to appropriate review and documentation. In 2007, 40% of
all subprime loans were generated by automated underwriting. The chairman of the Mortgage
Bankers Association claimed mortgage brokers profited from a home loan boom but did not do
enough to examine whether borrowers could repay. Mortgage fraud has also increased.
Securitization practices
Borrowing under a securitization structure.
Securitization is structured finance process in which assets, receivables or financial instruments
are acquired, pooled together as collateral for the third party investments (Investment banks).
There are many parties involved. Due to the securitization, investor appetite for mortgage-backed
securities (MBS), and the tendency of rating agencies to assign investment-grade ratings to
MBS, loans with a high risk of default could be originated, packaged and the risk readily
transferred to others. Asset securitization began with the structured financing of mortgage pools
in the 1970s. In 1995 the Community Reinvestment Act (CRA) was revised to allow for the
securitization of CRA loans into the secondary market for mortgages.
The traditional mortgage model involved a bank originating a loan to the borrower/homeowner
and retaining credit (default) risk. With the advent of securitization, the traditional model has
given way to the originate to distribute model, in which the credit risk is transferred
(distributed) to investors through MBS. The securitized share of subprime mortgages (i.e., those
passed to third-party investors via MBS) increased from 54% in 2001, to 75% in 2006.
Securitization accelerated in the mid-1990s. The total amount of mortgage-backed securities
issued almost tripled between 1996 and 2007, to $7.3 trillion. The debt associated with the
origination of such securities was sometimes placed by major banks into off-balance sheet
entities called structured investment vehicles or special purpose entities. Moving the debt off
the books enabled large financial institutions to circumvent capital reserve requirements,
thereby assuming additional risk and increasing profits during the boom period. Such off-balance
sheet financing is sometimes referred to as the shadow banking system and is thinly regulated.
Alan stated that the securitization of home loans for people with poor credit not the loans
themselves were to blame for the current global credit crisis.
However, instead of distributing mortgage-backed securities to investors, many financial
institutions retained significant amounts. The credit risk remained concentrated within the banks
instead of fully distributed to investors outside the banking sector. Some argue this was not a
flaw in the securitization concept itself, but in its implementation.
Some believe that mortgage standards became lax because of a moral hazard, where each link in
the mortgage chain collected profits while believing it was passing on risk.Under the CRA
guidelines, a bank gets credit originating loans or buying on a whole loan basis, but not holding
the loans. So, this gave the banks the incentive to originate loans and securitize them, passing the
risk on others. Since the banks no longer carried the loan risk, they had every incentive to lower
their underwriting standards to increase loan volume. The mortgage securitization freed up cash
for banks and thrifts, this allowed them to make even more loans. In 1997, Bear Sterns bundled
the first CRA loans into MBS.
Inaccurate credit ratings
Credit rating agencies and the subprime crisis
MBS credit rating downgrades, by quarter.
Credit rating agencies are now under scrutiny for giving investment-grade ratings to
securitization transactions (CDOs and MBSs) based on subprime mortgage loans. Higher ratings
were believed justified by various credit enhancements including over-collateralization (pledging
collateral in excess of debt issued), credit default insurance, and equity investors willing to bear
the first losses. However, there are also indications that some involved in rating subprime-related
securities knew at the time that the rating process was faulty. Internal rating agency emails from
before the time the credit markets deteriorated, released publicly by U.S. congressional
investigators, suggest that some rating agency employees suspected at the time that lax standards
for rating structured credit products would produce widespread negative results. For example,
one 2006 email between colleagues at Standard & Poors states Rating agencies continue to
create and [sic] even bigger monsterthe CDO market. Lets hope we are all wealthy and retired
by the time this house of cards falters.
High ratings encouraged the flow of investor funds into these securities, helping finance the
housing boom. The reliance on ratings by these agencies and the intertwined nature of how
ratings justified investment led many investors to treat securitized products some based on
subprime mortgages as equivalent to higher quality securities and furthered by SEC removal
of regulatory barriers and reduced disclosure requirements in the wake of the scandal. Critics
claim that conflicts of interest were involved, as rating agencies are paid by the firms that
organize and sell the debt to investors, such as investment banks. On 11 June 2008 the U.S.
Securities and Exchange Commission proposed far-reaching rules designed to address perceived
conflicts of interest between rating agencies and issuers of structured securities.
Rating agencies lowered the credit ratings on $1.9 trillion in mortgage backed securities from Q3
2007 to Q2 2008. This places additional pressure on financial institutions to lower the value of
their MBS. In turn, this may require these institutions to acquire additional capital, to maintain
capital ratios. If this involves the sale of new shares of stock, the value of existing shares is
reduced. In other words, ratings downgrades pressured MBS and stock prices lower.
Government policies
Government policies and the subprime mortgage crisis
Both government action and inaction have contributed to the crisis. Several critics have
commented that the current regulatory framework is outdated. President George W. Bush stated
in September 2008: Once this crisis is resolved, there will be time to update our financial
regulatory structures. Our 21st century global economy remains regulated largely by outdated
20th century laws. The Securities and Exchange Commission (SEC) has conceded that self-
regulation of investment banks contributed to the crisis. Increasing home ownership was a goal
of both Clinton and Bush administrations.
[80][81][82]
There is evidence that the government
influenced participants in the mortgage industry, including Fannie Mae and Freddie Mac (the
GSE), to lower lending standards.
[83][84][85]
The U.S. Department of Housing and Urban
Developments mortgage policies fueled the trend towards issuing risky loans.
In 1995, the GSE began receiving government incentive payments for purchasing mortgage
backed securities which included loans to low income borrowers. This resulted in the agencies
purchasing subprime securities. Subprime mortgage loan originations surged by 25% per year
between 1994 and 2003, resulting in a nearly ten-fold increase in the volume of these loans in
just nine years. These securities were very attractive to Wall Street, and while Fannie and
Freddie targeted the lowest-risk loans, they still fueled the subprime market as a result. In 1996
the Housing and Urban Development (HUD) agency directed the GSE to provide at least 42% of
their mortgage financing to borrowers with income below the median in their area. This target
was increased to 50% in 2000 and 52% in 2005. By 2008, the GSE owned or guaranteed nearly
$5 trillion in mortgages and mortgage-backed securities, close to half the outstanding balance of
U.S. mortgages. The GSE were highly leveraged, having borrowed large sums to purchase
mortgages. When concerns arose regarding the ability of the GSE to make good on their
guarantee obligations in September 2008, the U.S. government was forced to place the
companies into a conservatorship, effectively nationalizing them at the taxpayers expense.
Liberal economist Robert Kuttner has criticized the repeal of the Glass-Steagall Act by the
Gramm-Leach-Bliley Act of 1999 as possibly contributing to the subprime meltdown, although
other economists disagree. A taxpayer-funded government bailout related to mortgages during
the savings and loan crisis may have created a moral hazard and acted as encouragement to
lenders to make similar higher risk loans.
Additionally, there is debate among economists regarding the effect of the Community
Reinvestment Act, with detractors claiming it encourages lending to uncreditworthy consumers
and defenders claiming a thirty year history of lending without increased risk. Detractors also
claim that amendments to the CRA in the mid-1990s, raised the amount of home loans to
otherwise unqualified low-income borrowers and also allowed for the first time the securitization
of CRA-regulated loans containing subprime mortgages.
Policies of central banks
Central banks are primarily concerned with managing monetary policy; they are less concerned
with avoiding asset bubbles, such as the housing bubble and dot-com bubble. Central banks have
generally chosen to react after such bubbles burst to minimize collateral impact on the economy,
rather than trying to avoid the bubble itself. This is because identifying an asset bubble and
determining the proper monetary policy to properly deflate it are a matter of debate among
economists.
Federal Reserve actions raised concerns among some market observers that it could create a
moral hazard. Some industry officials said that Federal Reserve Bank of New York involvement
in the rescue of Long-Term Capital Management in 1998 would encourage large financial
institutions to assume more risk, in the belief that the Federal Reserve would intervene on their
behalf.
A contributing factor to the rise in home prices was the lowering of interest rates earlier in the
decade by the Federal Reserve, to diminish the blow of the collapse of the dot-com bubble and
combat the risk of deflation. From 2000 to 2003, the Federal Reserve lowered the federal funds
rate target from 6.5% to 1.0%. The central bank believed that interest rates could be lowered
safely primarily because the rate of inflation was low and disregarded other important factors.
The Federal Reserves inflation figures, however, were flawed. Richard W. Fisher, President and
CEO of the Federal Reserve Bank of Dallas, stated that the Federal Reserves interest rate policy
during this time period was misguided by this erroneously low inflation data, thus contributing to
the housing bubble.
Financial institution debt levels and incentives
Leverage Ratios of Investment Banks Increased Significantly 20032007
Many financial institutions borrowed enormous sums of money during 20042007 and made
investments in mortgage-backed securities (MBS), essentially betting on the continued
appreciation of home values and sustained mortgage payments. Borrowing at a lower interest
rate to invest at a higher interest rate is using financial leverage. This is analogous to an
individual taking out a second mortgage on their home to invest in the stock market. This
strategy magnified profits during the housing boom period, but drove large losses after the bust.
Financial institutions and individual investors holding MBS also suffered significant losses as a
result of widespread and increasing mortgage payment defaults or MBS devaluation beginning in
2007 onward.
A SEC regulatory ruling in 2004 greatly contributed to US investment banks ability to take on
additional debt, which was then used to purchase MBS. The top five US investment banks each
significantly increased their financial leverage during the 20042007 time period (see diagram),
which increased their vulnerability to the MBS losses. These five institutions reported over $4.1
trillion in debt for fiscal year 2007, a figure roughly 30% the size of the U.S. economy. Three of
the five either went bankrupt (Lehman Brothers) or were sold at fire-sale prices to other banks
(Bear Stearns and Merrill Lynch) during September 2008, creating instability in the global
financial system. The remaining two converted to commercial bank models, subjecting
themselves to much tighter regulation.
In 2006, Wall Street executives took home bonuses totaling $23.9 billion, according to the New
York State Comptrollers Office. Wall Street traders were thinking of the bonus at the end of
the year, not the long-term health of their firm. The whole systemfrom mortgage brokers to
Wall Street risk managersseemed tilted toward taking short-term risks while ignoring long-
term obligations. The most damning evidence is that most of the people at the top of the banks
didnt really understand how those [investments] worked.
Credit default swaps
Credit defaults swaps (CDS) are insurance contracts, typically used to protect bondholders or
MBS investors from the risk of default. As the financial health of banks and other institutions
deteriorated due to losses related to mortgages, the likelihood that those providing the insurance
would have to pay their counterparties increased. This created uncertainty across the system, as
investors wondered which companies would be forced to pay to cover defaults.
CDS may be used to insure a particular financial exposure or may be used speculatively. Trading
of CDS increased 100-fold from 1998 to 2008, with debt covered by CDS contracts ranging from
U.S. $33 to $47 trillion as of November 2008 CDS are lightly regulated. During 2008, there was
no central clearinghouse to honor CDS in the event a key player in the industry was unable to
perform its obligations. Required corporate disclosure of CDS-related obligations has been
criticized as inadequate. Insurance companies such as AIG, MBIA, and Ambac faced ratings
downgrades due to their potential exposure due to widespread debt defaults. These institutions
were forced to obtain additional funds (capital) to offset this exposure. In the case of AIG, its
nearly $440 billion of CDS linked to MBS resulted in a U.S. government bailout.
In theory, because credit default swaps are two-party contracts, there is no net loss of wealth. For
every company that takes a loss, there will be a corresponding gain elsewhere. The question is
which companies will be on the hook to make payments and take losses, and will they have the
funds to cover such losses. When investment bank Lehman Brothers went bankrupt in September
2008, it created a great deal of uncertainty regarding which financial institutions would be
required to pay off CDS contracts on its $600 billion in outstanding debts. Significant losses at
investment bank Merrill Lynch were also attributed in part to CDS and especially the drop in
value of its unhedged mortgage portfolio in the form of Collateralized Debt Obligations after
American International Group ceased offering CDS on Merrils CDOs. Trading partners loss of
confidence in Merril Lynchs solvency and ability to refinance short-term debt ultimately led to
its sale to Bank of America.
Impact of Financial crisis:
Financial crisis of 20072008 and Global financial crisis of 2008
Financial sector downturn
List of writedowns due to subprime crisis
FDIC Graph U.S. Bank & Thrift Profitability by Quarter
Financial institutions from around the world have recognized subprime-related losses and write-
downs exceeding U.S. $501 billion as of August 2008. Profits at the 8,533 U.S. banks insured by
the FDIC declined from $35.2 billion to $646 million (89%) during the fourth quarter of 2007
versus the prior year, due to soaring loan defaults and provisions for loan losses. It was the worst
bank and thrift quarterly performance since 1990. For all of 2007, these banks earned
approximately $100 billion, down 31% from a record profit of $145 billion in 2006. Profits
declined from $35.6 billion to $19.3 billion during the first quarter of 2008 versus the prior year,
a decline of 46%.
The financial sector began to feel the consequences of this crisis in February 2007 with the $10.5
billion writedown of HSBC, which was the first major CDO or MBO related loss to be reported.
During 2007, at least 100 mortgage companies either shut down, suspended operations or were
sold. Top management has not escaped unscathed, as the CEOs of Merrill Lynch and Citigroup
were forced to resign within a week of each other.
[124]
various institutions followed up with
merger deals.
Market weaknesses, 2007
On July 19, 2007, the Dow Jones Industrial Average hit a record high, closing above 14,000 for
the first time.
On August 15, 2007, the Dow dropped below 13,000 and the S&P 500 crossed into negative
territory for that year. Similar drops occurred in virtually every market in the world, with Brazil
and Korea being hard-hit. Through 2008, large daily drops became common, with, for example,
the KOSPI dropping about 7% in one day,
[127][dead link]
although 2007s largest daily drop by the
S&P 500 in the U.S. was in February, a result of the subprime crisis.
Mortgage lenders and home builders
[130][131][dead link]
fared terribly, but losses cut across sectors,
with some of the worst-hit industries, such as metals & mining companies, having only the
vaguest connection with lending or mortgages.
Stock indices worldwide trended downward for several months since the first panic in July
August 2007.
Market downturns and impacts, 2008
The TED spread an indicator of credit risk increased dramatically during September 2008.
The crisis caused panic in financial markets and encouraged investors to take their money out of
risky mortgage bonds and shaky equities and put it into commodities as stores of value.
Financial speculation in commodity futures following the collapse of the financial derivatives
markets has contributed to the world food price crisis and oil price increases due to a
commodities super-cycle. Financial speculators seeking quick returns have removed trillions
of dollars from equities and mortgage bonds, some of which has been invested into food and raw
materials.
Beginning in mid-2008, all three major stock indices in the United States (the Dow Jones
Industrial Average, NASDAQ, and the S&P 500) entered a bear market. On 15 September 2008,
a slew of financial concerns caused the indices to drop by their sharpest amounts since the 2001
terrorist attacks. That day, the most noteworthy trigger was the declared bankruptcy of
investment bank Lehman Brothers. Additionally, Merrill Lynch was joined with Bank of
America in a forced merger worth $50 billion. Finally, concerns over insurer American
International Groups ability to stay capitalized caused that stock to drop over 60% that day.
Poor economic data on manufacturing contributed to the days panic, but were eclipsed by the
severe developments of the financial crisis. All of these events culminated into a stock selloff
that was experienced worldwide. Overall, the Dow Jones Industrial plunged 504 points (4.4%)
while the S&P 500 fell 59 points (4.7%). Asian and European markets rendered similarly sharp
drops.
The much anticipated passage of the $700 billion bailout plan was struck down by the House of
Representatives in a 228205 vote on September 29. In the context of recent history, the result
was catastrophic for stocks. The Dow Jones Industrial Average suffered a severe 777 point loss
(7.0%), its worst point loss on record up to that date. The NASDAQ tumbled 9.1% and the S&P
500 fell 8.8%, both of which the worst losses were those indices experienced since the 1987
stock market crash.
Despite congressional passage of historic bailout legislation, which was signed by President
Bush on Saturday, Oct. 4, Dow Jones Index tumbled further when markets resumed trading on
Oct. 6. The Dow fell below 10,000 points for the first time in almost four years, losing 800
points before recovering to settle at -369.88 for the day.Stocks also continued to tumble to record
lows ending one of the worst weeks in the Stock Market since September 11, 2001.
It is also estimated that even with the passing of the so-called bailout package; many banks
within the United States will tumble and therefore cease operating. It is estimated that over 100
banks in the United States will close their doors because of the financial crisis. This will have a
severe impact on the economy and consumers. It is expected that it will take years for the United
States to recover from the crisis.
Indirect economic effects
Indirect economic effects of the subprime mortgage crisis
The subprime crisis had a series of other economic effects. Housing price declines left
consumers with less wealth, which placed downward pressure on consumption. Certain minority
groups received a higher proportion of subprime loans and experienced a disproportional level of
foreclosures. Home related crimes including arson increased. Job losses in the financial sector
were significant, with over 65,400 jobs lost in the United States as of September 2008.
Many renters became innocent victims, often evicted from their homes without notice due to
foreclosure of their landlords property. In October 2008, Tom Dart, the elected Sheriff of Cook
County, Illinois, criticized mortgage companies for their actions, and announced that he was
suspending all foreclosure evictions.
The sudden lack of credit also caused a slump in car sales. Ford sales in October 2008 were
down 33.8% from a year ago, General Motors sales were down 15.6%, and Toyota sales had
declined 32.3%. One in five car dealerships are expected to close in fall of 2008.
Financial Crisis Likely impact on Bangladesh
The stock price plunge and severe credit crunch we are watching
today in global financial markets are
byproducts of the developments in the US six years ago. In late 2001, fears of global terror
attacks after 9/11 shook an already struggling US economy, one that was just beginning to come
out of the recession induced by the bursting of the dotcom bubble of late 1990s.
In response, during 2001, the Federal Reserve, the US central bank, began cutting interest rates
dramatically to encourage borrowing, which spurred both consumption and investment spending.
As lower interest rates worked their way into the economy, the real estate market began to get
itself into frenzy. The number of homes sold and the prices they sold for increased dramatically,
beginning in 2002. At the time, the rate on a 30-year fixed rate mortgage was at the lowest levels
seen in nearly 40 years.
Subprime and similar mortgage originations in the US rose from less than 8 percent of all
mortgages in 2003 to over 20 percent in 2006.
The crisis began with the bursting of the US housing bubble and high default rates on subprime
and adjustable rate mortgages, beginning in approximately 2005-2006. For a number of years
prior to that, declining lending standards, an increase in loan incentives such as easy initial terms,
and a long-term trend of rising housing prices had encouraged borrowers to assume difficult
mortgages in the belief they would be able to quickly refinance at more favorable terms.
However, once interest rates began to rise and housing prices started to drop in 2006-2007 in
many parts of the US, refinancing became more difficult. Default and foreclosure activity
increased dramatically as easy initial terms expired, home prices failed to go up as anticipated,
and adjustable rate mortgage interest rates reset higher. Foreclosures accelerated in the United
States in late 2006 and triggered a global financial crisis through 2007 and 2008.
Initially the companies affected were those directly involved in home construction and mortgage
lending. Financial institutions, which had engaged in the securitization of mortgages, fell prey
subsequently. The rest is history.
The crisis is still unfolding. There remains great uncertainty as to the depth and severity of the
crisis as well as its impact on the real sectors (so called main streets) in US and Europe. This
makes it difficult to assess clearly how it will impact Bangladesh.
However, overall, there is absolutely no reason to panic. Bangladesh is relatively insulated from
the financial side, but vulnerable to potential global economic slowdown, particularly in the US
and EU. The foreign exchange reserves of Bangladesh Bank and commercial banks have limited
exposure to the securities markets and banking system risk in the US and EU.
Foreign capital flows are largely in the form of concessional official lending. FDI and foreign
portfolio investments are small. However, Bangladeshs economy relies heavily on garment
exports. This is where the main risk lies. Remittances may also be vulnerable. On the positive
side, import payments may be favorably affected as a result of declining commodity prices,
particularly oil and food.
The export sector is potentially the most vulnerable in Bangladesh since it depends heavily on
US and EU economies. The readymade garment (RMG) industry accounts for over three quarters
of export earnings and depends almost entirely on US and EU markets. There is growing concern
that a deep and prolonged recession in the US and EU may reduce consumer spending
significantly across the board, thus undermining the demand for Bangladeshi exports. BGMEA
and BKMEA have indicated that growth in export orders was slow in the first quarter of Fy08.
IMF has projected that income growth in Bangladeshs export markets will decline from 1.5
percent in 2008 to 0.5 percent in 2009. If this happens, consumer spending will decline.
Although demand for Bangladeshs exports is not too sensitive to income, export prices may
decline and this could have significant effects on our export earnings even if export volumes
remain largely unaffected.
There is unlikely to be any direct immediate impact on remittances. Remittances in Bangladesh
proved to be resilient during previous financial crises in the world. The bulk (over 60 percent) of
Bangladeshs remittances come from the Middle East, and less than one-third come from the US,
UK and Germany. Strong remittance growth (44 percent) has continued in the first quarter of
FY09.
However, if a deep and protracted recession ensues in the US and EU, then the Middle-Eastern
economies are likely to be adversely affected. Stock markets in important Middle-Eastern
economies have already started to crash. Even if the current nearly $8 billion level of remittances
is sustained, it would be challenging to maintain its growth momentum since 2001 if the world
economy remains depressed for an extended period.
Official aid flows may take a hit. Governments in rich donor countries are doling out massive
amounts to rescue their domestic financial institutions. They may look for savings from other
sources to finance these bailouts. Foreign aid budget is relatively easy to cut since the foreign aid
recipients do not count as their voters.
Import is probably the one channel through which Bangladesh may benefit. Import payments in
August have reportedly been US$531 million lower than import payments in July. This decline
in import payments is mainly due to the fall in prices of petroleum products, wheat and edible
oil. Record high oil prices last year raised import payments to over US$20 billion in FY08,
compared to slightly over US$15 billion in payments in FY07. The gains on account of reduced
import payments can be sizable.
While mindful of the risks, early indications in FY09 are that the economy is on track to
achieving the 6.5 percent growth projected by the government. Agricultural production outlook
so far looks very good, export growth in July was exceptionally strong (71 percent), and service
sector growth should maintain its recent growth trend.
Bangladeshs remarkable resilience so far to this ongoing global financial crisis and slowing
growth in high-income countries is in large part because of the countrys relative insulation from
international capital markets and the negligible role played by foreign portfolio investors in the
country. This resilience also derives from sound policy framework and macroeconomic
fundamentals. However, investor psychology is much less insulated than the capital market
itself, as demonstrated by the sudden increase in volatility in Dhaka and Chittagong Stock
Exchanges last Sunday (October 12).
The overall financial leverage in Bangladesh is low. Unlike the global financials, Bangladeshs
banking system has no toxic derivative engagements. Barring a prolonged slowdown in the
world economy leading to a drastic reduction in RMG exports, it is highly unlikely that the
external shocks will increase the risk of asset quality problems or precipitate a credit crunch in
Bangladesh. This is due to Bangladeshs low level of external debt, robust international reserves,
and limited direct exposure to the international financial system.
Low level of global integration shields Bangladesh from the global financial turmoil. However,
Bangladesh is far from being completely insulated. Its heavy dependence on US and EU markets
for merchandize exports is a real source of vulnerability as are remittances and foreign aid,
though may be to a lesser extent. There is therefore no alternative to stronger policy vigilance
and preparedness.
Policy makers have to make sure that markets do not panic by continuously providing evidence
on the economys resilience in various sectors. They must proactively monitor the channels
through which the global financial turmoil may start creeping into the Bangladesh economy and
take appropriate mitigation measures.
Inflation has recently been the biggest macro policy challenge in Bangladesh. With the
aggravation of the financial turmoil we have seen a sharp decline in global commodity prices.
This makes the inflation battle a little easier for Bangladeshi policymakers. But new policy
dilemmas are likely to emerge if export earnings begin to slow down and currencies of
Bangladeshs competitor countries depreciate. This will put exchange rate policy under pressure
to maintain export competitiveness.
Market interventions aimed at depreciating the currency will dilute through declining
international commodity prices to domestic prices and, consequently, undermine the objective of
reducing inflation from its current double-digit level.
For Bangladesh a more momentous shock over the past couple of years has been the soaring
price of commodities, which some have also blamed on financial speculation. The food-price
spike in late 2007 and early 2008 caused havoc to the lives of the poor and middle-income
groups. In response, the government extended its reach by increasing subsidies and expanding
safety nets. FY09 budget has already built-in an expansionary stance to continue providing
support to the poor so that they can afford to pay the high food prices.
If manufacturing is hit badly by recession in western economies, there will be fresh demand for
further expansion of safety nets and increase in direct and indirect subsidies to exports. This will
call for some more tough choices, accommodate these demands through increased domestic
borrowing and/or restrain other spending if additional concessional financing cannot be
mobilized from external sources.
Crisis so severe, the world financial system is affected
Following a period of economic boom, a financial bubble-global in scope-has now burst.
A collapse of the US sub-prime mortgage market and the reversal of the housing boom in other
industrialized economies have had a ripple effect around the world. Furthermore, other
weaknesses in the global financial system have surfaced. Some financial products and
instruments have become so complex and twisted, that as things start to unravel, and trust in the
whole system started is failing. The extent of this problem has been so severe that some of the
worlds largest financial institutions have collapsed. Others have been bought out by their
competition at low prices and in other cases, the governments of the wealthiest nations in the
world have resorted to extensive bail-out and rescue packages for the remaining large banks and
financial institutions. The effect of this, the United Nations Conference on Trade and
Development says in its Trade and Development Report 2008 is, as summarized by the Third
World Network, that The global economy is teetering on the brink of recession. The downturn
after four years of relatively fast growth is due to a number of factors: the global fallout from the
financial crisis in the United States, the bursting of the housing bubbles in the US and in other
large economies, soaring commodity prices, increasingly restrictive monetary policies in a
number of countries, and stock market volatility. the fallout from the collapse of the US
mortgage market and the reversal of the housing boom in various important countries has turned
out to be more profound and persistent than expected in 2007 and beginning of 2008. As more
and more evidence is gathered and as the lag effects are showing up, we are seeing more and
more countries around the world being affected by this rather profound and persistent negative
effects from the reversal of housing booms in various countries.
Crisis so severe, those responsible are bailed out
Some of the bail-outs have also been accompanied with charges of hypocrisy due to the
appearance of socializing the costs while privatizing the profits. The bail-outs appear to help
the financial institutions that got into trouble (many of whom pushed for the kind of lax policies
that allowed this to happen in the first place).Some governments have moved to make it harder to
manipulate the markets by shorting during the financial crisis blaming them for worsening an
already bad situation. It should be noted that during the debilitating Asian financial crisis in the
late 1990s, Asian nations affected by short-selling complained, without success that currency
speculators-operating through hedge funds or through the currency operations of commercial
banks and other financial institutions-were attacking their currencies through short selling and in
doing so, bringing the rates of the local currencies far below their real economic levels.
However, when they complained to the Western governments and IMF, they dismissed the
claims of the Asian governments, blaming it on their own economic mismanagement instead.
Other governments have moved to try and reassure investors and savers that their money is safe.
In a number of European countries, for example, governments have tried to increase or fully
guarantee depositors savings. In other cases, banks have been nationalized (socializing profits as
well as costs, potentially.)In the meanwhile, smaller businesses and poorer people rarely have
such options for bail out and rescue when they find themselves in crisis. There seems to be a
growing resentment and little sympathy for those working in the financial sector that appeared to
have gambled with peoples money, and hence their lives, while even getting fat bonuses and
pay rises for it in the past. Although in raw dollar terms the huge pay rises and bonuses are small
compared to the magnitude of the problem, the encouragement such practices have given in the
past, as well as the type of culture it creates is what has angered so many people.
In the case of subprime mortgages, it is also argued that those who took on the risky loans are to
blame; they should not have borrowed so much money when they knew they would not have the
means to repay. While there is truth to this, and our culture of expecting easy money, consuming
beyond our means, etc is something that needs urgent attention, in the case of subprime
mortgages, it seems easy to forget the predicament of people living in poverty. Financial advisors
that irresponsibly pushed these loans (with no interest or care of the borrower in mind) were
generally aggressive as they had a lot to gain from these loans.
For people living in poverty even in wealthy countries life can be desperate and miserable.
Concerns will range from crime in the neighborhood, to good schooling, to getting by week by
week on very little, and ensuring a job lasts. The hope of being able to escape it for a while was,
in effect, exploited. When in poverty, long term thinking is not always going to enter the realm
of immediate concern. Furthermore, it is likely that those lower down the social strata are not
going to be as financially savvy as those further up. Hence there is usually more trust placed in a
bank or financial advisor. It is often forgotten these days that banks and financial institutions
have changed in nature; there is less concern about the people they serve, but more about how
they can sell products from which they can make profit. While to some extent risky borrowers
may bear some responsibility, overall they lost out while the lenders are being bailed out.
A crisis so severe, the rest suffer too
There is the argument that when the larger banks show signs of crisis, it is not just the wealthy
that will suffer, but potentially everyone. With an increasingly inter-connected world, things like
a credit crunch can ripple through the entire economy.
For example, people may find their mortgages harder to pay, or remortgaging could become
expensive, for any recent homebuyers the value of their homes are likely fall in value leaving
them in negative equity, and many sectors may find the credit crunch and higher costs of
borrowing will lead to job cuts. As people will cut back on consumption to try and weather this
economic storm, yet other businesses will struggle to survive leading to further fears of job
losses.
The financial crisis and wealthy countries
Many have blamed the greed of Wall Street for causing the problem in the first place because it
is in the US that the most influential banks, institutions and ideologues that pushed for the
policies that caused the problems are found.
The crisis became so severe that after the failure and buyouts of major institutions, the Bush
Administration offered a $700 billion bailout plan for the US financial system.
This bailout package was controversial because it was unpopular with the public, seen as a
bailout for the culprits while the ordinary person would be left to pay for their folly. The initial
rejection at the US House of Representatives, because of this, sent shock waves around the
world. It took a second attempt to pass the plan, but with add-ons to the bill to get the additional
congressmen and women to accept the plan.
However, as former Nobel prize winner for Economics, former Chief Economist of the World
Bank and university professor at Columbia University, Joseph Stiglitz, argued, the plan remains
a very bad bill: I think it remains a very bad bill. It is a disappointment, but not a surprise, that
the administration came up with a bill that is again based on trickle-down economics. You throw
enough money at Wall Street, and some of it will trickle down to the rest of the economy. Its
like a patient suffering from giving a massive blood transfusion while theres internal bleeding; it
doesnt do anything about the basic source of the hemorrhaging, the foreclosure problem. But
that having been said, it is better than doing nothing, and hopefully after the election, we can
repair the very many mistakes in it.Writing in The Guardian, Stiglitz also added that,
Americans have lost faith not only in the [Bush] administration, but in its economic philosophy:
a new corporate welfarism masquerading behind free-market ideology; another version of
trickle-down economics, where the hundreds of billions to Wall Street that caused the problem
were supposed to somehow trickle down to help ordinary Americans. Trickle-down hasnt been
working well in America over the past eight years.
The very assumption that the rescue plan has to help is suspect. After all, the IMF and US
treasury bail-outs for Wall Street 10 years ago in Korea, Thailand, Indonesia, Brazil, Russia and
Argentina didnt work for those countries, although it did enable Wall Street to get back most of
its money. The taxpayers in these other poor countries picked up the tab for the financial
markets mistakes. This time, it is American taxpayers who are being asked to pick up the tab.
And thats the difference. For all the rhetoric about democracy and good governance, the citizens
in those countries didnt really get a chance to vote on the bail-outs. In environmental
economics, there is a basic concept called the polluter pays principle. It is a matter of fairness,
but also of efficiency. Wall Street has polluted our economy with toxic mortgages. It should now
pay for the cleanup.
The financial crisis and the developing world
For the developing world, the rise in food prices as well as the knock-on effects from the
financial instability and uncertainty in industrialized nations are having a compounding effect.
High fuel prices, soaring commodity prices together with fears of global recession are worrying
many developing country analysts. Summarizing a United Nations Conference on Trade and
Development report, the Third World Network notes the impacts the crisis could have around the
world, especially on developing countries that are dependent on commodities for import or
export: Uncertainty and instability in international financial, currency and commodity markets,
coupled with doubts about the direction of monetary policy in some major developed countries,
are contributing to a gloomy outlook for the world economy and could present considerable risks
for the developing world, the UN Conference on Trade and Development (UNCTAD) said
Thursday. Commodity-dependent economies are exposed to considerable external shocks
stemming from price booms and busts in international commodity markets.
Market liberalization and privatization in the commodity sector have not resulted in greater
stability of international commodity prices. There is widespread dissatisfaction with the
outcomes of unregulated financial and commodity markets, which fail to transmit reliable price
signals for commodity producers. In recent years, the global economic policy environment seems
to have become more favorable to fresh thinking about the need for multilateral actions against
the negative impacts of large commodity price fluctuations on development and macroeconomic
stability in the world economy.
Asia and the financial crisis
Countries in Asia are increasingly worried about what is happening in the West. A number of
nations urged the US to provide meaningful assurances and bailout packages for the US
economy, as that would have a knock-on effect of reassuring foreign investors and helping ease
concerns in other parts of the world. Many believe Asia was sufficiently de-coupled from the
Western financial systems, but this crisis has shown that this is not the case, at least not yet.
Many Asian countries have seen their stock markets suffer and currency values going on a
downward trend. As many nations in the region are seeing rapid growth and wealth creation,
there is enormous investment in Western countries, and therefore, a lot of exposure to problems,
too. In addition, there is increased foreign investment, mostly from the West in Asia. Asian
products and services are also global, and a slowdown in wealthy countries means increased
chances of a slowdown in Asia and the risk of job losses. Asia has not had a subprime mortgage
crisis like many nations in the West, but the increasingly inter-connected world means there are
always knock-on effects.
Conclusion:
In summary, while the crisis is not over yet, we certainly hope the worst is behind us.
Corrective action is still needed and the lessons we are learning are ongoing. That said, we
have learned, in fact re-learned, that while crises may manifest themselves in different ways,
with new instruments, in new markets, and sometimes in newly created types of institutional
frameworks, one of the items that remains the same is that incentives are often at the root of a
crisis. Often altering incentives is a difficult job as market participants and the official sector
have gotten comfortable in their various roles, rules, and regulations. But it is time to re-evaluate
how incentives altered the buildup to the latest crisis and its aftermath and how they can be
redirected to reinforce self-corrective forces in financial markets rather than destructive ones.
The Fund can play a role in putting forth possible options, joining with various international
organizations and standard setters to discuss them, and acting as a focal point for such
discussions, and can help disseminate the new best practices or rule-making throughout its
membership to foster a more secure global economic and financial environment.
The global financial crisis, brewing for a while, really started to show its effects in the middle of
2008. Around the world stock markets have fallen, large financial institutions have collapsed or
been bought out, and governments in even the wealthiest nations have had to come up with
rescue packages to bail out their financial systems.
On the one hand many people are concerned that those responsible for the financial problems are
the ones being bailed out, while on the other hand, a global financial meltdown will affect the
livelihoods of almost everyone in an increasingly inter-connected world. The problem could
have been avoided, if ideologues supporting the current economics models werent so vocal,
influential and inconsiderate of others viewpoints and concerns.

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