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Project on

Financial crises of 2007

Presented to
Sir Humza Mukhtar


Hira Majid
Background and causes
Financial market impacts
Responses to financial crises
Banks default in U.S.A
The financial crisis of 2007 is a crisis triggered by a liquidity crisis in the United States banking
system. It has resulted in the collapse of large financial institutions, the bailout of banks by
national governments and downturns in stock markets around the world. In many areas, the
housing market has also suffered, resulting in numerous, foreclosures. It is considered by many
economists to be the worst financial crisis since the Great Depression of the 1930s.] It contributed
to the failure of key businesses, declines in consumer wealth estimated in the trillions of U.S.
dollars, substantial financial commitments incurred by governments, and a significant decline in
economic activity. Many causes have been proposed, with varying weight assigned by
experts. Both market-based and regulatory solutions have been implemented or are under
consideration, while significant risks remain for the world economy over the 2010–2011 periods.

Background and causes

The immediate cause or trigger of the crisis was the bursting of the United States housing
bubble which peaked in approximately 2005–2006. High default rates on "sub prime"
and adjustable rate mortgages (ARM) began to increase quickly thereafter. 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.

Low interest rates and large inflows of foreign funds created easy credit conditions for a number
of years prior to the crisis, fueling a housing construction boom and encouraging debt-financed
consumption. The combination of easy credit and money inflow contributed to the United States
housing bubble. Loans of various types (e.g., mortgage, credit card, and auto) were easy to
obtain and consumers assumed an unprecedented debt load. As part of the housing and credit
booms, the number of financial agreements called mortgage-backed securities (MBS)
and collateralized debt obligations (CDO), which derived their value from mortgage payments and
housing prices, greatly increased. Such financial innovation enabled institutions and investors
around the world to invest in the U.S. housing market. As housing prices declined, major global
financial institutions that had borrowed and invested heavily in sub prime MBS reported
significant losses. Policymakers did not recognize the increasingly important role played by
financial institutions such as investment banks and hedge funds, also known as the shadow
banking system.

Growth of the housing bubble

Between 1997 and 2006, the price of the typical American house increased by
124%.This housing bubble resulted in quite a few homeowners refinancing their homes at lower
interest rates, or financing consumer spending by taking out second mortgages secured by the
price appreciation. Giant Pool of Money" (represented by $70 trillion in worldwide fixed income
investments) sought higher yields than those offered by U.S. Treasury bonds early in the decade.
Further, this pool of money had roughly doubled in size from 2000 to 2007, yet the supply of
relatively safe, income generating investments had not grown as fast. Investment banks on Wall
Street answered this demand with the MBS and CDO, which were assigned safe ratings by
the credit rating agencies. The CDO in particular enabled financial institutions to obtain investor
funds to finance sub prime and other lending, extending or increasing the housing bubble and
generating large fees. By September 2008, average U.S. housing prices had declined by over
20% from their mid-2006 peak.[ As prices declined, borrowers with adjustable-rate mortgages
could not refinance to avoid the higher payments associated with rising interest rates and began
to default. During 2007, lenders began foreclosure proceedings on nearly 1.3 million properties, a
79% increase over 2006.This increased to 2.3 million in 2008, an 81% increase vs. 2007. By
August 2008, 9.2% of all U.S. mortgages outstanding were either delinquent or in foreclosure. By
September 2009, this had risen to 14.4%.

Easy credit conditions

Lower interest rates encourage borrowing. From 2000 to 2003, the Federal Reserve lowered
the federal funds rate target from 6.5% to 1.0%.This was done to soften the effects of the
collapse of the dot-com bubble and of the September 2001 terrorist attacks, and to combat the
perceived risk of deflation. Additional downward pressure on interest rates was created by the
USA's high and rising current account (trade) deficit, which peaked along with the housing bubble
in 2006.Bernanke explained that between 1996 and 2004, the USA current account deficit
increased by $650 billion, from 1.5% to 5.8% of GDP. Financing these deficits required the USA
to borrow large sums from abroad, much of it from countries running trade surpluses, mainly the
emerging economies in Asia and oil-exporting nations. The balance of payments identity requires
that a country (such as the USA) running a current account deficit also have a capital
account(investment) surplus of the same amount. Hence large and growing amounts of foreign
funds (capital) flowed into the USA to finance its imports. This created demand for various types
of financial assets, raising the prices of those assets while lowering interest rates. Foreign
investors had these funds to lend, either because they had very high personal savings rates (as
high as 40% in China), or because of high oil prices. Foreign governments supplied funds by
purchasing USA Treasury bonds and thus avoided much of the direct impact of the crisis. USA
households, on the other hand, used funds borrowed from foreigners to finance consumption or
to bid up the prices of housing and financial assets. Financial institutions invested foreign funds
in mortgage-backed securities. The Fed then raised the Fed funds rate significantly between
July 2004 and July 2006. This contributed to an increase in 1-year and 5-yearadjustable-rate
mortgage (ARM) rates, making ARM interest rate resets more expensive for home owners. This
may have also contributed to the deflating of the housing bubble, as asset prices generally move
inversely to interest rates and it became riskier to speculate in housing’s and financial assets
dramatically declined in value after the housing bubble burst.

Sub-prime lending

The term sub prime refers to the credit quality of particular borrowers, who have weakened credit
histories and a greater risk of loan default than prime borrowers. The value of U.S. sub prime
mortgages was estimated at $1.3 trillion as of March 2007, with over 7.5 million first-lien sub
prime mortgages outstanding.

In addition to easy credit conditions, there is evidence that both government and competitive
pressures contributed to an increase in the amount of sub prime lending during the years
preceding the crisis. Major U.S. investment banks and government sponsored enterprises
like Fannie Mae played an important role in the expansion of higher-risk lending.

Sub prime mortgages remained below 10% of all mortgage originations until 2004, when they
spiked to nearly 20% and remained there through the 2005-2006 peak of the United States
housing bubble A proximate event to this increase was the April 2004 decision by the U.S.
Securities and Exchange Commission (SEC) to relax the net capital rule, which permitted the
largest five investment banks to dramatically increase their financial leverage and aggressively
expand their issuance of mortgage-backed securities. This applied additional competitive
pressure to Fannie Mae and Freddie Mac, which further expanded their riskier lending. Sub prime
mortgage payment delinquency rates remained in the 10-15% range from 1998 to 2006, then
began to increase rapidly, rising to 25% by early 2008.

Some, like American Enterprise Institute fellow Peter J. Wallis on believe the roots of the crisis
can be traced directly to sub-prime lending by Fannie Mae and Freddie Mac, which is
government, sponsored entities. On 30 September 19,
Critics have argued that the regulatory framework did not keep pace with financial innovation,
such as the increasing importance of the shadow banking system, derivatives and off-balance
sheet financing. In other cases, laws were changed or enforcement weakened in parts of the
financial system. Key examples include:

 In October 1982, U.S. President Ronald Reagan signed into Law the Garn-St. Germain
Depository Institutions Act, which began the process of Banking deregulation that helped
contribute to the savings and loan crises of the late 1980s/early 1990s, and the financial
crises of 2007-2010.
 In November 1999, U.S. President Bill Clinton signed into Law the Gramm-Leach-Bliley
Act, which repealed part of the Glass-Steagall Act of 1933. This repeal has been criticized for
reducing the separation between commercial banks (which traditionally had a conservative
culture) and investment banks (which had a more risk-taking culture).

Increased debt burden or over-leveraging

U.S. households and financial institutions became increasingly indebted or overleveraged during
the years preceding the crisis. This increased their vulnerability to the collapse of the housing
bubble and worsened the ensuing economic downturn. Key statistics include:

 Free cash used by consumers from home equity extraction doubled from $627 billion in
2001 to $1,428 billion in 2005 as the housing bubble built, a total of nearly $5 trillion dollars
over the period, contributing to economic growth worldwide. U.S. home mortgage debt
relative to GDP increased from an average of 46% during the 1990s to 73% during 2008,
reaching $10.5 trillion.

 USA household debt as a percentage of annual disposable personal income was 127%
at the end of 2007, versus 77% in 1990.

 In 1981, U.S. private debt was 123% of GDP; by the third quarter of 2008, it was 290%.

Financial innovation and complexity

The term financial innovation refers to the ongoing development of financial products designed to
achieve particular client objectives, such as offsetting a particular risk exposure (such as the
default of a borrower) or to assist with obtaining financing. Examples pertinent to this crisis
included: the adjustable-rate mortgage; the bundling of sub prime mortgages into mortgage-
backed securities (MBS) or collateralized debt obligations (CDO) for sale to investors, a type
of securitization; and a form of credit insurance called credit default swaps (CDS). The usage of
these products expanded dramatically in the years leading up to the crisis. These products vary in
complexity and the ease with which they can be valued on the books of financial institutions.

Certain financial innovation may also have the effect of circumventing regulations, such as off-
balance sheet financing that affects the leverage or capital cushion reported by major banks.

Commodity bubble
A commodity price bubble was created following the collapse in the housing bubble. The price
of oil nearly tripled from $50 to $147 from early 2007 to 2008, before plunging as the financial
crisis began to take hold in late 2008. Experts debate the causes, which include the flow of
money from housing and other investments into commodities to speculation and monetary
policy or the increasing feeling of raw materials scarcity in a fast growing world economy and
thus positions taken on those markets, such as Chinese increasing presence in Africa. An
increase in oil prices tends to divert a larger share of consumer spending into gasoline, which
creates downward pressure on economic growth in oil importing countries, as wealth flows to oil-
producing states.

In testimony before the Senate Committee on Commerce, Science, and Transportation on June
3, 2008, former director of the CFTC Division of Trading & Markets (responsible for enforcement)
Michael Greenberger specifically named the Atlanta-based Intercontinental Exchange, founded
by Goldman Sachs, Morgan Stanley and British Petroleum as playing a key role in the
speculative run-up of oil futures prices traded off the regulated futures exchanges in London and
New York. It was also noticed that a copper price bubble was occurring at the same time as the
oil bubble. Copper traded at about $2,500 per tone from 1990 until 1999, when it fell to about
$1,600. The price slump lasted until 2004 which saw a price surge that had copper reaching
$7,040 per tone in 2008. As of February 2010 copper was trading at about $6,500 per tone and
slowly falling.

Nickel prices boomed in the late 1990s, and then the price of nickel imploded from
around $51,000 /£36,700 per metric ton in the May of 2007 to about $11,550/£8,300 per
metric ton in the January of 2009. Prices were only just starting to recover as of January
2010, but most of Australia's nickel mines had gone bankrupt by then. As the price for
high grade nickel sulphate ore recovered in 2010, so did the Australian mining industry.
Financial markets impacts
Impacts on financial institutions
The International Monetary Fund estimated that large U.S. and European banks lost more than
$1 trillion on toxic assets and from bad loans from January 2007 to September 2009. These
losses are expected to top $2.8 trillion from 2007-10. U.S. banks losses were forecast to hit $1
trillion and European bank losses will reach $1.6 trillion. The IMF estimated that U.S. banks were
about 60 percent through their losses, but British and euro zone banks only 40 percent.

One of the first victims was Northern Rock, a medium-sized British bank. The highly leveraged
nature of its business led the bank to request security from the Bank of England. This in turn led
to investor panic and a bank run in mid-September 2007 Initially the companies affected were
those directly involved in home construction and mortgage lending such as Northern Rock and
Countrywide Financial, as they could no longer obtain financing through the credit markets. Over
100 mortgage lenders went bankrupt during 2007 and 2008. Concerns that investment bank Bear
Stearns would collapse in March 2008 resulted in its fire-sale to JP Morgan Chase. The crisis hit
its peak in September and October 2008. Several major institutions either failed, were acquired
under duress, or were subject to government takeover

Wealth effects
There is a direct relationship between declines in wealth, and declines in consumption and
business investment, which along with government spending represent the economic engine.
Between June 2007 and November 2008, Americans lost an estimated average of more than a
quarter of their collective net worth. By early November 2008, a broad U.S. stock index the S&P
500 was down 45 percent from its 2007 high. Housing prices had dropped 20% from their 2006
peak, with futures markets signaling a 30-35% potential drop. Total home equity in the United
States, which was valued at $13 trillion at its peak in 2006, had dropped to $8.8 trillion by mid-
2008 and was still falling in late 2008 Total retirement assets, Americans' second-largest
household asset, dropped by 22 percent, from $10.3 trillion in 2006 to $8 trillion in mid-2008.
During the same period, savings and investment assets (apart from retirement savings) lost $1.2
trillion and pension assets lost $1.3 trillion. Taken together, these losses total a staggering $8.3
trillion. Since peaking in the second quarter of 2007 household wealth is down $14 trillion.

Further, U.S. homeowners had extracted significant equity in their homes in the years leading up
to the crisis, which they could no longer do once housing prices collapsed. Free cash used by
consumers from home equity extraction doubled from $627 billion in 2001 to $1,428 billion in
2005 as the housing bubble built, a total of nearly $5 trillion over the period. U.S home mortgage
debt relative to GDP increased from an average of 46% during the 1990s to 73% during 2008,
reaching $10.5 trillion.
To offset this decline in consumption and lending capacity, the U.S. government and U.S.
Federal Reserve have committed $13.9 trillion, of which $6.8 trillion has been invested or
spent, as of June 2009.In effect, the Fed has gone from being the "lender of last resort" to
the "lender of only resort" for a significant portion of the economy. In some cases the Fed
can now be considered the "buyer of last resort."
Responses to financial crisis
Emergency and short-term responses
The U.S. Federal Reserve and central banks around the world have taken steps to expand
money supplies to avoid the risk of a deflationary spiral, in which lower wages and higher
unemployment lead to a self-reinforcing decline in global consumption. In addition, governments
have enacted large fiscal stimulus packages, by borrowing and spending to offset the reduction in
private sector demand caused by the crisis. The U.S. executed two stimulus packages, totaling
nearly $1 trillion during 2008 and 2009.

This credit freeze brought the global financial system to the brink of collapse. The response of the
U.S. Federal Reserve, the European Central Bank, and other central banks was immediate and
dramatic. 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. The governments
of European nations and the USA also raised the capital of their national banking systems by
$1.5 trillion, by purchasing newly issued preferred stock in their major banks.

Governments have also bailed out a variety of firms as discussed above, incurring large financial
obligations. To date, various U.S. government agencies have committed or spent trillions of
dollars in loans, asset purchases, guarantees, and direct spending.

Regulatory proposals and long-term responses

United States President Barack Obama and key advisers introduced a series of regulatory
proposals in June 2009. The proposals address consumer protection, executive pay, bank
financial cushions or capital requirements, expanded regulation of the shadow banking
system and derivatives, and enhanced authority for the Federal Reserve to safely wind-down
systemically important institutions, among others. The U.S. Senate is currently considering
financial reform legislation which would create a new Bureau of Consumer Financial Protection
(as part of the Federal Reserve) and make sales of most derivatives take place through a public
A variety of other regulatory changes have been proposed by economists, politicians, journalists,
and business leaders to minimize the impact of the current crisis and prevent recurrence. None of
the proposed solutions have yet been implemented. These include:

 Ben Bernanke: Establish resolution procedures for closing troubled financial institutions in
the shadow banking system, such as investment banks and hedge funds.
 Warren Buffett: Require minimum down payments for home mortgages of at least 10%
and income verification.
 Eric Dinallo: Ensure any financial institution has the necessary capital to support its
financial commitments. Regulate credit derivatives and ensure they are traded on well-
capitalized exchanges to limit counterparty risk
 Raghuram Rajan: Require financial institutions to maintain sufficient "contingent capital"
(i.e., pay insurance premiums to the government during boom periods, in exchange for
payments during a downturn.).
 HM Treasury: Contingent capital or capital insurance held by the private sector could
supplement common equity in times of crisis. There are a variety of proposals (e.g. Raviv
2004, Flannery 2009) under which banks would issue fixed income debt that would convert
into capital according to a predetermined mechanism, either bank-specific (related to levels of
regulatory capital) or a more general measure of crisis
 A. Michael Spence and Gordon Brown: Establish an early-warning system to help
detect systemic risk
 Nouriel Roubini: Nationalize insolvent banks Reduce mortgage balances to assist
homeowners, giving the lender a share in any future home appreciation.
 at riskier businesses paid more. The second, more complex tax aims directly at excess
bank profit and pay.

Assets at time of
Bank City State Date
Riverside National Bank of Florida Fort Pierce Florida 2010 $3.4 billion
City Bank Lynnwood Washington 2010 $1.1 billion
Washington Mutual Seattle Washington 2008 $307 billion
Continental Illinois National Bank
Chicago Illinois 1984 $40.0 billion
and Trust
First Republic Bank Dallas Texas 1988 $32.5 billion
Indy Mac Pasadena California 2008 $32 billion
American Savings and Loan Stockton California 1988 $30.2 billion
Colonial Bank Montgomery Alabama 2009 $25 billion
Bank of New England Boston Massachusetts 1991 $21.7 billion
MCorp Dallas Texas 1989 $18.5 billion
FBOP Corp banking subsidiaries Oak Park Illinois 2009 $18.4 billion
Gibraltar Savings and Loan Simi Valley California 1989 $15.1 billion
First City National Bank Houston Texas 1988 $13.0 billion
Guaranty Bank Austin Texas 2009 $13.0 billion
Downey Savings and Loan Newport Beach California 2008 $12.8 billion
Bank United FSB Coral Gables Florida 2009 $12.8 billion
Home Fed Bank San Diego California 1992 $12.2 billion
Am Trust Bank Cleveland Ohio 2009 $12.0 billion
United Commercial Bank San Francisco California 2009 $11.2 billion
Southeast Bank Miami Florida 1991 $11.0 billion
Goldome Buffalo New York 1991 $9.9 billion
California National Bank Los Angeles California 2009 $7.8 billion
Corus Bank Chicago Illinois 2009 $7.0 billion
First Federal Bank of California Santa Monica California 2009 $6.1 billion
Franklin Bank Houston Texas 2008 $5.1 billion
Silverton Bank Atlanta Georgia 2009 $4.1 billion
Imperial Capital Bank La Jolla California 2009 $4.0 billion
PFF Bank & Trust Pomona California 2008 $3.7 billion
La Jolla Bank La Jolla California 2010 $3.6 billion
First National Bank of Nevada Reno Nevada 2008 $3.4 billion
Irwin Union Bank and Trust
Columbus Indiana 2009 $2.7 billion
Orion Bank Naples Florida 2009 $2.7 billion
ANB Financial Bentonville Arkansas 2008 $2.1 billion
First Regional Bank Los Angeles California 2010 $2.1 billion
Silver State Bank Henderson Nevada 2008 $2.0 billion
New Frontier Bank Greeley Colorado 2009 $2.0 billion
Georgian Bank Atlanta Georgia 2009 $2.0 billion
Vineyard Bank California 2009 $1.9 billion
Peoples First Community Bank Panama City Florida 2009 $1.8 billion
County Bank Merced California 2009 $1.7 billion
Mutual Bank Harvey Illinois 2009 $1.6 billion
Community Bank of Nevada Las Vegas Nevada 2009 $1.5 billion
First Bank of Beverly Hills Calabasas California 2009 $1.5 billion
Temecula Valley Bank Temecula California 2009 $1.5 billion
New South Federal Savings Bank Irondale Alabama 2009 $1.5 billion
Horizon Bank Bellingham Washington 2010 $1.3 billion
Security Bank of Bibb County Macon Georgia 2009 $1.2 billion
Charter Bank Santa Fe New Mexico 2010 $1.2 billion
Alliance Bank Culver City California 2009 $1.1 billion
Integrity Bank Alpharetta Georgia 2008 $1.1 billion
Columbia River Bank The Dalles Oregon 2010 $1.1 billion
Community Bank and Trust Cornelia Georgia 2010 $1.1 billion
Affinity Bank Ventura California 2009 $1.0 billion
Advanta Bank Corp Draper Utah 2010 $1.6 billion
Appalachian Community Bank Ellijay Georgia 2010 $1.0 billion
Amcore Bank Rockford Illinois 2010 $3.4 billion
Broadway Bank Chicago Illinois 2010 $1.2 billion
CF Bancorp Port Huron Michigan 2010 $1.6 billion
Eurobank En Español San Juan Puerto Rico 2010 $2.6 billion
Frontier Bank Everett Washington 2010 $3.5 billion
R-G Premier Bank of Puerto Rico Hato Rey Puerto Rico 2010 $5.9 billion
Westernbank Puerto Rico En Español Mayaguez Puerto Rico 2010 $11.9 billion