The Financial Crisis 2008-2010

Reasons, Impacts & Counter Measures

Saad Hanif Academia Research

This document encompasses the reasons behind the failure of the American banking system, and how it lead to a financial catastrophe around the world. It discusses the causes of the crisis, the impact they had on market fundamentals, and what steps have been initiated by the Govt. and the Fed to restore the banking system stability.

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The Global Financial Crisis

Introduction
The global financial crisis which started in early 2007 has proven to be perhaps the great financial catastrophe in history. Although it traces its roots back to the starting of the millennia, the subsequent meltdown was most gruesome over the past 3 years. What began as a crisis of the sub-prime mortgage market in the United States quickly transcended national borders and developed into a upheaval of epic proportions. What ensued was a systematic debacle of stock exchanges, investment banking, derivatives etc. all financial markets ranging from equity, currency, real estate, futures etc. In order to fully understand the devastation caused by this dilemma, we have to take focus on the core issues and identify the stream of events as they occurred and how they subsequently collapsed global financial markets.

Housing Bubble Burst

The global financial crisis began through the US sub-prime mortgage market. The past two decades leading up to the year 2005 had experienced phenomenal growth in terms of increases in housing prices. There was an abundance of capital flowing into the country and this translated into excess liquidity available for banks to lend out. The Sub-Prime Mortgage Market refers to a market where people with bad credit history can obtain house loans at relatively better rates. It doesnt imply that the interest rates are low, but rather they dont have to go through the rigors they would face due to their poor credit rating. Since the US is the largest consumption economy in the world, which implies the use of credit facilities, banks started encouraging consumers to

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avail these easy loans. The housing bubble experienced its pinnacle in 2005-06, which was the main indicator that the bubble would collapse in a similar manner to the Dot Com era. Default rates on sub prime and adjustable rate mortgages (ARM) began to increase quickly as the market witnessed growth of consumers. This was augmented by the rise in prices of the housing sector due to demand pressures. Thus banks were successfully convincing customers to engage in credit facilities as the market prices seemed to show substantial hikes in value. Consumers were so busy buying houses that they missed the interest charge they would have to bear over the years. The structure of such contracts was that the first 2 years would be a fixed, flat rate, after which the rate mechanism would be ARM. Thus banks succeeded in creating a large pool of assets associated with high risk profiles. As Malhar Nabar from Wellesley College points out in his article US Policy Response to the Financial Crisis, The lending boom and the increase in house prices that it supported resulted from a combination of factors a buildup of liquidity in financial markets and a subsequent search for yield in a low interest rate environment, the erosion of lending standards, and the deterioration in the metrics used by creditrating agencies to rate the financial securities involved.

Asset Securitization of Sub-Prime Loans

The banks that were lending in the sub prime market were also busy in another set of transactions, one of which was passing on the risk of these assets to other institutional investors. The process of securitization involves the restructuring of a pool of assets including loans, real estate etc into viable investments. In this case, mortgage-backed securities and collateralized debt-obligations were the instruments utilized. Investment Banks and various financial corporations purchased these instruments with the understanding they were safe investments.

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These included investors from the US, the EU and some parts of Asia. Extremely complex derivatives were employed to mask the risk profiles of the assets, such as credit default swaps. Off-balance sheet items were increasing, known as SPVs or Special Purpose Vehicles where bad loans and defaulting assets were parked as a separate entity so that the parent company seemed to be doing prosperously. When the interest rates in the US were raised in 2007, the consumers using the ARM mechanism started to default on payments. As the delinquency ratio increased for the market, the banks that had given the loans started charging more risk premium. This in turn increased the defaults. At the same time, the housing bubble came crashing down and prices of real estate fell drastically. Customers who planned to use the house they had loaned to repay the debt in case of defaults now realized that their houses had lost a significant proportion of its value. With the asset now worthless and the debt obligation constantly rising, the housing bubble became a nightmare for the consumers. On the other hand, the institutional investors who had purchased the CDOs and MBSs now realized that theyre money had eroded over night. Due to this revaluation of the asset value, Bear Stearns, a Financial Powerhouse, lost approximately $5 billion through the erosion of the existing value of its assets. This is just one of the many firms which took the brunt of this collapse. As the losses began to sink in and liquidity became short, these institutions starting pulling their money out from various other investments they had made around the world. This triggered a freefall of indices on a global scale including in Japan, UK, EU etc. and not to mention on its own turf like the Dow Jones.

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Key Factors of the Crisis

Thus, the factors involved in the financial debacle of the 2007 can be summarized as mortgage underwriting, mortgage fraud, predatory lending, housing speculation, excessive leveraging, financial innovation, regulatory avoidance, inaccurate credit ratings etc. the amalgamation of this factors is the global meltdown we see crippling the economics of the world.

The Negative Implications of the Debacle

The Financial Crisis had an imposing presence on financial institutions around the world, but the initial shocks were absorbed by banks of the USA and a couple of UK banks. The IMF has estimated that the losses of the crisis are nearing the $3 Trillion mark. These toxic loans affected many banks who had directly or indirectly involved themselves with the sub-prime mortgage securities. Investment banks like Bear Stearns realized the shortfall in liquidity, and accordingly opted to arrange funds through the divestiture of their other investments. This led to the spreading of the financial crisis on a global scale. It also triggered panic sell-outs at dirt cheap prices to other relatively more stable institutions. Commercial banks were not spared from this fate either, with depositors withdrawing their money rapidly for the fear that banks were becoming insolvent. This bank run sucked up even more liquidity from the market and all lines of credit were being closed. Flipping the coin, money markets also began to experience withdrawal. Mutual Funds regularly invest in commercial paper issued by the different corporations who use the funds to continue operations. These funds are also used to meet short term debt obligations. When liquidity started becoming scarce, the mutual funds opted to withdraw their money from this market, resulting in a liquidity crisis for corporations which had nothing to do with the sub-prime market. Without the ability to generate funds, these companies found it difficult to maintain their interest payment

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cycle. Without being able to roll over their obligations, they were slowly beginning to dwindle. The Federal Reserve took immediate action by extending insurance for money market accounts via temporary guarantees. They also initiated programs by which the FED would buy commercial paper from these corporations. The shadow banking industry was perhaps the one hit the hardest. Shadow Banking refers to financial institutions which do not have a depository base, but engage in investment transactions. They had grown to a substantial size up till 2007, almost equal to the conventional banking sector in terms of importance. Without the ability to obtain investor funds in exchange for most types of mortgage-backed securities or asset-backed commercial paper, investment banks and other entities in the shadow banking system could not provide funds to mortgage firms and other corporations. The liquidity crunch crippled the shadow banking sector, and many reputable firms suffered dire consequences. Several major institutions which failed, were acquired under duress, or were subject to government takeover included Lehman Brothers, Merrill Lynch, Fannie Mae, Freddie Mac, Washington Mutual, Wachovia, and AIG.

Short Term Initiatives to Overcome the Crisis

After witnessing the financial crisis, a lot of measures were taken to counteract the negative consequences. The Federal Reserve in an attempt to stabilize the monetary system and maintain abundant liquidity embarked on an expansionary monetary policy regime. The discount rate was brought to from 5.25% to .25 % in gradual declines. Now it ranges from 0% to 0.25% on float. Open market operations or OMOs as they are referred to, were conducted to ensure that liquidity was available to the market. Apart from that, the Fed initiated a $600 billion program to purchase mortgage backed securities of government sponsored enterprises (GSE). The Federal

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Open Market Committee opted to further enhance this exposure by purchasing an additional $750 billion worth of GSEs. The Fed also developed lending mechanisms to lend directly to banks and non-bank institutions, against specific types of collateral of varying credit quality. The Govt. also created stimulus packages to jumpstart the business cycle and get the economy back into gear. In 2008, the Govt. issued income tax rebates worth $168 billion directly to tax payers. However higher fuel and food costs negated the desired effect this stimulus would have had. In 2009, the U.S. Govt. passed the American Recovery and Reinvestment Act of 2009, a $787 billion stimulus package with a broad spectrum of spending and tax cuts. This was by far the largest bailout in the history of financial debacles. 10% of this amount was directed towards the assistance of the struggling homeowners. The Govt also initiated the Troubled Assets Relief Program, under which banks would be provided funding in exchange for dividend paying Preferred stock. Apart from providing a stimulus package, the Govt. also provided bail out packages to some large corporations, while approved the mergers of others. The decline in the value of mortgagebacked securities which these corporations held lead to their insolvency, the same as bank runs when investors pulled funds from them, or inability to secure new funding in the credit markets. These firms had typically leveraged themselves and invested large sums of money relative to their cash or equity capital. This increased their susceptibility to unanticipated credit market disruptions. Some prominent names that were sold off to other corporations include Merrill Lynch and Bear Stearns, while others who were bailed out by the Govt include Morgan Stanley and Goldman Sachs.

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Long Term Focus on Stability

Once the initial measures were set into motion, a number of economists, politicians, journalists and business leaders focused on implementing long term austerity measures to ensure the debacle could be overcome and that in the future, regulatory frameworks would be such that the banking system would be able to maintain its robustness. Some of the recommendations included: Restrict the leverage a financial institution can assume. Require financial institutions to maintain adequate contingent capital. Regulate firms which operate in a capacity similar to banks. Enforce the regulatory framework so that fraudulent activities can be curbed. Reduce debt levels across the financial system through debt for equity swaps.

Conclusion
While the measures taken by the Fed and Treasury may seem at first glance to be ad hoc, with the authorities appearing to selectively intervene on an institution by institution basis, it is possible to trace out an underlying coherence to the strategy pursued. Ultimately, there is no unique template for dealing with a financial crisis of this magnitude. The crisis has now moved on from the US to the European Union, with Greece being the first to face the debt crisis, followed by other members including Spain, Ireland, and Portugal etc. The losses have mounted into trillions of dollars with the IMF estimations that the US has witnessed 60% of the losses it should, while the EU is still at 40%. The debt market has started taking its toll on other markets

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including currency, futures, forwards etc. what remains to be seen is a structured approach to ensure that the worst that has passed will not be repeated.

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References Nabar, Malhar, December 16 2008, Rewriting the rule rook: The US policy response to the financial crisis 2007-08, Retrieved from: http://www.wellesley.edu/Economics/Nabar/__files/response_121608.pdf Butler, Willem H., December 2007, Lessons from the financial crisis 2007, retrieved from: http://www.cepr.org/pubs/policyinsights/PolicyInsight18.pdf Allayannis, Yiorgos, July 07 2009, The financial crisis of 2007-2009: The road to systemic risk, Retrieved from http://hbr.org/product/the-financial-crisis-of-2007-2009-the-road-to-syst/an/UV2551PDF-ENG Conklin, David W., June 09 2008, The 2007-2008 Financial Crisis: Causes, impacts and the need for new regulations, Retrieved from: http://hbr.org/product/the-2007-2008-financial-crisis-causes-impacts-and-/an/908N14PDF-ENG Rampell, Catherine, January 03 2010, Lax Oversight Caused Crisis, Bernanke Says, Retrieved from : http://www.nytimes.com/2010/01/04/business/economy/04fed.html

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Lazzaro, Joseph, November 4 2010, Bernanke on the Financial Crisis: Interventions Prevented
Cataclysm, Retrieved from:

http://www.dailyfinance.com/story/bernanke-on-the-financial-crisis-interventionsprevented-catacl/19433654/