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US Financial crises;

By; Abdul Ghaffar (SP09-MBO-037)

FINANCIAL CRISES

Financial Crisis:

Financial crisis is a situation; “where disruptions in financial markets rise to the level of a crisis
when the flow of credit to household and business is constrained and the real economy of goods
and services is adversely affected”

How Financial Crises Started In US:

Recent financial crises in US were triggered from the default of real estate loan advanced by the
financial institution of USA. With the meltdown of property market in US the values of
properties became lesser than the value of loan outstanding.

After 9/11 attacks, Federal Reserve of USA has announced declined in the interest rate. Before
the financial crises, significant amounts of foreign money flowed into the U.S. from fast-growing
economies in Asia and oil-producing countries due to relaxed economic policies of US. This
inflow of funds made it easier for the Federal Reserve to keep interest rates in the United States
too low which contributed to easy credit condition. Due to low interest rate and relaxed term of
loan, every one in the economy accessed to financial institution for different kind of loan. Loan
for purchase of real estate has increased, that increased the demand for real estate in USA. Due
to increased demand of houses, prices of houses have increased.

Borrower started taking consumer loan by mortgaging the previously mortgaged houses in form
 
of second mortgage because the value of houses has increased. Housing loans made by the
financial institution to people with little support made these loans very risky, and when interest
rates rose, these borrowers could no more repay. Financial institution took initiative to recover
the loan by selling the mortgages. During 2007, prices of houses have declined due to
foreclosure of mortgaged by the financial institution due to default of borrower. Supply of
houses in market has increased, that causes declined in the prices of houses. Due to declining
prices of loan, financial institution became unable to recover the full amount of loan outstanding.
Liquidity position of financial institution has declined that caused the collapse of financial
institution.

For Example: Lehman Brothers became bankrupt as a large part of their loan portfolio
comprised of loans for buying real estate. With the meltdown in the property market in US the
values of properties became lesser than the value of loan outstanding. The huge $60 billion loss
in bad real estate loans forced the bank to file for bankruptcy.

Reference; Michael Jay Friedman, “Outline of U.S. Economy”, 2009 Edition 


ELEMENT OF FINANCIAL CRISES
THE U.S. economy is currently experiencing its worst crisis since the Great Depression. The
crisis started in the home mortgage market, especially the market for so-called “subprime”
mortgages, and is now spreading beyond subprime to prime mortgages, commercial real estate,
corporate junk bonds, and other forms of debt.

Meltdown of Real Estate Market:

Real sector in US was in boom during 2006, due to higher demand for houses in USA. This
higher demand of houses was due to huge amount of advances by US financial institution to low
income group and first time home buyer. Due to increasing value of houses, borrower started
taking further loans by mean of second mortgage of their houses. Higher value of houses was
enough to cover the first and second mortgage loans at that time. But housing boom finally
collapsed in 2007 due to increasing number of foreclosure by banks that caused decline in prices
of houses. Worth of loan outstanding was more than the worth of mortgages. That caused the
huge losses to financial sector of USA. For Example: bankruptcy of Lehman brothers. So
meltdown of real estate market was the initial cause for the financial crises of USA.

Easy credit Terms:

US Federal Reserve lowered interest rate from 2000 to 2003 to combat the risk of deflation after
9/ 11 attacks. Lower interest rate encouraged excessive borrowing to low income groups and
high risk customers. Due to increasing competition, financial institution attracted lot of
customers by lending them on easy credit terms with out recognizing the risk of default. Easy
credit term for the borrowers has increased the amount of advances to customers by the banks.
But in the last quarter of 2006, higher interest rates and declining value of mortgages converted
the banks loans into bad loans. So easy credit terms, caused excessive lending and thus higher
default rate caused huge losses to the financial sector.

US Current Account Deficit:

From 1996 to 2004, US current account deficit increased by 1.5% to 5.8% of GDP. USA
borrowed large sum from emerging economies in Asia and oil exporting nations. Huge amount
of foreign funds flowed into the USA to finance the current account deficit. Demand for financial
assets increased and interest rate declined. US households borrowed huge amount from
foreigners to finance consumption thus increasing the prices of financial assets and houses. But
after few years due to increasing interest rate, borrowers could not be able to pay back the loans.
So US borrowing for managing current account deficit also contributed to current financial crises
of the USA.

Lending to Riskier segment:


The term subprime loan is used for the loans to less creditworthy borrowers in USA. Competitive
environment forced the financial institution to advance subprime loans. Major US investment
banks and State sponsored enterprises like Fannie Mae contributed to higher risk lending in years
preceding the crisis. Worth of subprime loan has increased in 2005-2006, that increased the risk
of investment banks. Relaxed capital rule of Securities and Exchange Commission has also
increase the amount of risky loan. Government pressure to state sponsored enterprises to expand
mortgage loans to low and moderate income people also caused the financial institute to face
huge losses in last quarter of 2007.

Debit to Equity Ratio:

Level of indebtedness of US households and financial institutions has increased during the years
preceding the crises. Loan to low and moderate income people was more than that of their
disposable personal income. According to data on website of Federal Reserve; from 2004-2007,
the top five US investment banks increase their financial leverage which increased their risk.
Due to overleveraged Lehman Brothers was liquidated; Bear Stearns and Merrill Lynch were
sold at low prices.

Relaxed Economic Policies:

Relaxed government policies increased the level of foreign investment in USA. Due to
increasing competition rate of profit for US firms declined that affected the growth rate of
corporation.

Regulatory Frame Work:

Regulatory frame work did not keep pace with innovation in financial products and financial
instruments. General Accepted Accounting Principles still have confusion with respect to
recording of different assets and liabilities, like contingent liabilities, off balance sheet financing.
Off-balance sheet entities were also used by Enron as part of the scandal that brought down that
company in 2001. Derivative market in USA was out of regulatory frame work that caused huge
losses to financial institution. Investment banks in US are not regulated by Fed, excessive
lending and higher debt ratio of investment banks contributed to financial crises in USA.

Lack of Corporate Governance:

US corporate scandals are also contributed to bankruptcy of different corporation in USA. Enron,
one of leading energy sector companies hide billion of debt from failed deals and projects. Audit
firm of Enron, Arther Anderson was closed because of involvement in Enron scandal. CEO of
Lehman brother also received million of dollars under bonuses and share option before the
liquidation of the company. Off balance sheet finance and creative accounting practices were
occurring on routine basis. Ill corporate governance activities of different corporation also
contributed to the financial crises of the USA.

Reference; http://en.wikipedia.org/wiki/Subprime_mortgage_crisis
SECTORS AFFECTED BY FINANCIAL CRISES
Financial crises affected the following sector of US economy.

Banking Sector:

Banking sector in US severely affected by recent financial crises of USA. Banking sector faced
huge losses due to default of borrowers. According to IMF estimates, US banks hit by $1 trillion
losses due to bad loans. Investment Banks were initial victims of financial crises. Financial
institution involved in home construction and mortgage lending heavily affected by decreasing
prices of houses and default of borrows.

For Example:

9 The huge $60 billion loss in bad real estate loans forced the Lehman Brother to file for
bankruptcy.

9 Sale of Bear Stearns Investment banks to JP Morgan Chase

Real Estate Sector:

US financial crises were triggered by meltdown of real estate sector. Excessive lending for
houses increased the prices of houses. But during the last quarter of 2006, increasing interest rate
and higher rate of foreclosure by banks declined the prices of houses. Real sector heavily
affected by the financial crises of USA. Value of housed declined and borrowers become unable
to pay back the outstanding amount of loan by selling the houses. Declining prices of houses
triggered the financial crises in USA.

Stock Market:

Stock market is a market for corporation for raising finance for their investment activities. As
discussed above that financial crisis badly hit the investment banks. Investment banks help the
corporation by assisting Initial Public offering (IPOs). So the troubles of Investment Banks
affected the share market badly. Due to corporate scandals and higher interest rates, demand for
financial instrument has decreased. Prices of shares declined, demand for debt instrument and
lending trends felt down.

Industrial Sector:

The US financial crises also affected the industrial sector of USA. Purchasing power of
household declined due to high level of unemployment and falling disposable income of house
hold. Industrial sector also affected by tightening lending policies of the bank. Industries needs
loans for investment activities, due to high cost of capital it become difficult for the industries to
pursue investment activities.

Reference; Dell’Ariccia, Giovanni, Enrica Detragiache, and Raghuram Rajan (2004), “The
Real Effect of Banking Crises”, Mimeo, International Monetary Fund.
IMPACT OF FINANCIAL CRISES
Banks are central body for growth of whole economy. US financial crises heavily affected the
banking sector of US. The crisis has led to a sharp reduction in bank lending, which in turn is
causing a severe recession in the US economy.

Unemployment;

Financial crisis severely affected the working force of USA. Due to bankruptcy of different
financial institution, unemployment level in US has increased. Decreasing demand of goods and
services forced the companies to cut down production that caused high level of layoffs in USA.
According to US Work Force Bureau, unemployment rate increased to 10.2% by October 2009,
the highest rate since 1983.

Gross Domestic Product (GDP);

GDP is used to determine the overall level of economic activity within an economy. Financial
crisis led to national wide cuts in US production and employment. Investment, consumption,
government expenditure and net exports are the component of GDP. Investment activities
reduced due to decline in saving, consumption reduced due to unemployment, government
expenditure for development activities reduced, and Net exports of US also reduced. According
to estimates of IMF, GDP growth was 2% in 2007 and it reduced to 1.1% in 2008.

Inflation;

Economic experts are anticipating higher rate of inflation in coming year. Government is
planning to finance the bailouts via issuance of debt. Experts are of opinion that, it will be
difficult for the US to find buyers of its debt. It will simply need to print the money. Increase in
money supply will lead to inflation in US in coming year.

Investment;

Financial crises affected the level of investment in USA. Due to tightening loan policies of banks
and meltdown of credit market, it becomes difficult for the business to raise finance for their
investment activities.

Development Expenditure;

Government development expenditure for health, education, roads and schools has declined
because of bailout packages to the sick units of economy.

Reference:  Richard C. Cook, “Impacts of the Financial Crisis” The U.S. Is Becoming an
Impoverished Nation” Global Research, September 19, 2008
 
US GOVERNMENT POLICY

In the midst of the crises, Americans chose new national leadership in a peaceful transfer of
power to Barack Obama. Obama’s government responded to financial crises on priority basis.
US Congress adopted massive economic stimulus plan of federal funding, loans, and tax cuts to
bring the economy of USA on stable footing. Following policies adopted by Government to
tackle the financial crises of USA.

Monetary Policy:

During the last quarter of 2008, these central banks purchased US$2.5 trillion of government
debt and troubled private assets from banks. This was the largest liquidity injection into the
credit market, and the largest monetary policy action, in world history.

Bailout Policy:

US government have spent huge amount in bailout of straggling financial institution of USA.
The bailout policy of government saved different financial institution from bankruptcy. Such
policies also saved the economy from further crises. US Treasury Secretary Henry Paulson and
Fed Chairman Ben Bernanke met with key legislators to propose a $700 billion emergency
bailout. The Emergency Economic Stabilization Act also called the Troubled Asset Relief
Program (TARP) is signed into law on October 3, 2008

For Example;

Two home mortgage companies, Fannie Mae and Freddie Mac, were in danger of bankruptcy
due to collapse of mortgage industry. US government responded to this crisis by guaranteeing to
pay all their debts in full.

American International Group (AIG) was saved by an $85 billion capital injection by the federal
government

Regulatory Policies:

President Barack Obama and key advisers introduced different regulatory proposal in June 2009
to ensure best corporate governance in the financial institution of the USA. The main objectives
were to address consumer protection, executive pay, bank financial cushions and capital
requirement of financial institution.

For Example;

Following are few regulatory proposals to tackle the financial crises.

9 Regulate institution that act like banks.


9 Financial Institution must ensure necessary capital to support its financial commitment.

9 Ensure contingent capital to meet uncertain event.

9 Nationalization of insolvent banks.

Federal Reserve Policies:

Federal Reserve adopted following policies to meltdown the financial crises of USA.

• Lower Interest Rate:

We know that, financial institution in USA has decreased lending activities due to ill credit
worthiness of the borrowers. In order to increase the lending activities of the financial institution,
Fed declined the interest rate. However, these traditional policies can not be affective,
because the banks were unwilling to increase lending due to lack of trust in the credit
worthiness of the borrower and due to huge losses they have suffered from the default of
borrowers.

• Broaden the Eligible Collateral:

Lowering interest rate policy has not increased the level of lending; banks were unwilling to
advance loans due to high default rate of borrowers. In order to cope with threat of high default
rate, Federal Reserve broadened the eligible collateral for the loans. Previously only Treasury
bonds were eligible, but now all sorts of more risky securities are eligible, including mortgage-
based securities.

• Loan to Investment Bank:

The most important policy decided by Fed to extend loans to investment banks for the first time
in its history. For the first time, Fed acted as lender of last resort to investment bank because no
body was willing to lend to investment banks. Such lending has increased the liquidity position
of investment banks. Lending to investment saved the investment banks from bankruptcy; their
bankruptcy would have caused very widespread losses and could have resulted in complete
meltdown of the US financial system. For example; Fed lending to Bear Stearns investment
bank, saved the bank from bankruptcy.

 Reference; Fred Moseley; “The U.S. economic crisis: Causes and solutions” ISR Issue 64,
March–April 2009

Reference: “Federal Reserve Action”. Press Release, December 12, 2007


Bibliography

Website:
www.america.gov
www.bea.gov
www.bls.gov

Articles:

Peter Auer, Raphael Auer, Simon Wehrmiiler, “Assessing the impact of the financial
crises on the US labor market”, 21 November 2008.
Klingebiel, Daniela, Randall S. Kroszner, and Luc A. Laeven, and (June 2002),
“Financial Crises, Financial Dependence, and Industry Growth”, World Bank Policy
Research Working Paper No. 2855.

Others:

Obama-Regulatory Reform Speech June 17, 2009


New Documentary Reveals truth about financial crisis (Link;
http://mustafaqadri.net/wp/blog/documentary-on-us-financial-crisis/)

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