Financial Crisis 2008

What, Who, How and its aftermath

P. Suganthi

FINANCIAL CRISIS - Meaning

A situation in which the value of financial institutions or assets drops rapidly. A financial crisis is often

associated with a panic or a run on

the banks, in which investors sell off assets or withdraw money from savings accounts with the expectation that the value of those assets will drop if they remain at a financial institution.

RECESSION - Meaning
Recession - While there is no technical definition of a recession, they are conventionally defined by two or more consecutive quarters of negative GDP growth. A

recession is a significant decline in economic activity

spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.

Securitization
Securitization is the financial practice of pooling various types of contractual debt, such as residential mortgages, commercial mortgages, auto loans, or credit card debt obligations, and selling said consolidated debt as pass-through securities, or collateralized mortgage obligation (CMOs) to various investors. The cash collected from the financial instruments underlying

the security is paid to the various investors who had advance

money for that right. Securities backed by residential mortgage receivables are called residential-mortgage-backed securities

(RMBS), while those backed by other types of receivables are

asset-backed securities (ABS).

CDO, Bailout
CDO Collaterised Debt Obligation: A collateralized debt obligation (CDO) is a type of structured assetbacked security (ABS).

A bailout is a colloquial term for giving a loan to a

company or country which faces serious financial difficulty or bankruptcy.

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The Economic Crisis of 2008: Cause and Aftermath

Financial crisis How the economy felt

Collapse of large financial institutions Lehman brothers, Washington mutual, Worldcom,

GM
Bailout of banks by national governments
GM & Chrysler - $13.4 billion AIG - $180 billion

Downturn in stock market

 Decline in consumer wealth in trillions of US dollars (1 trillion US$ = Rs.600,00,00,00,00,000) Housing market suffered, foreclosures

Unemployment

Who - behind the crisis

US advocated - National Homeownership Strategy: Partners in the American Dream Easy credit conditions, Weak and fraudulent

underwriting practices, Predatory lending,

Deregulation from lending institutions Crash high mortgage payments, defaults, downgrading of CDO Role or no-honest role of credit rating agencies

How Crisis was handled

Emergency and short term responses: Liquidity injection upto US$2.5 trillion by Fed and other central banks, currency creation, purchase of pref. shares

of major banks
Regulatory and long term responses: Key proposals 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.

How India faced the crisis

Plummeting stock prices (SENSEX dropped from 21000 in Jan08 to below 10,000 in Oct08), a net outflow of foreign capital (upto $10.1bn), large reduction in foreign

exchange reserves, double digit inflation

Slowdown in domestic demand and exports, esp in housing, construction, IT, consumer durables, etc Unemployment job losses upto 500,000 in 2008 GDP decline from 9% in 2007 to 7% in 2008, around 5%

in 2009

 Indias relatively low level of exports21 percent of GDPhas insulated the country from the impact of the global recession.

Its state-dominated banking sector (more number of

nationalised banks), lesser number of branches outside India, conservative policies by RBI, and low risk appetite is said to have protected it to a large degree from the global financial meltdown.

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The Economic Crisis of 2008: Cause and Aftermath

Indias response to crisis

Monetary policy facilitating money expansion decrease in the rates of CRR, SLR, etc Credit support and subsidies

Economic response
Inclusive development spending on social sectors nad rural infrastructure: stepped up

Increase in allocation for school education

Bringing fiscal deficit under control and institutional reforms

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The Economic Crisis of 2008: Cause and Aftermath

EUROZONE Crisis
High public and private debts after transition to Euro by way of capital inflows however investments not very productive lesser returns from investments than

expected unable to repay debts debt levels in public

sector (Greece) and private sector as real estate and banking sector bubbles (Italy and Spain). Capital inflows increased domestic demand inflation set in prices up and competitiveness reduced lesser exports trade deficits increased

 Greece blamed for poor management rampant tax evasion high spends on government jobs and benefits Economic challenges high levels of public debt, weak

banking system, lack of economic growth, persistent trade

deficits, problem in the structure of eurozone

Crisis responses
Financial assistance Economic reforms Steps to improve liquidity in Eurozone

Restructuring of debt
Economic governance

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The Economic Crisis of 2008: Cause and Aftermath

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The Economic Crisis of 2008: Cause and Aftermath

What Caused the Crisis of 2008?

FACTOR 1: Beginning in the mid-1990s, government regulations began to erode the conventional lending standards.
Fannie Mae and Freddie Mac hold a huge share of American mortgages. Beginning in 1995, HUD regulations required Fannie Mae and Freddie Mac to increase their holdings of loans to low and moderate income borrowers. HUD regulations imposed in 1999 required Fannie and Freddie to accept more loans with little or no down payment. 1995 regulations stemming from an extension of the Community Reinvestment Act required banks to extend loans in proportion to the share of minority population in their market area. Conventional lending standards were reduced to meet these goals.

What Caused the Crisis of 2008?

FACTOR 2: The Feds manipulation of interest rates during 2002-2006 Fed's prolonged Low-Interest Rate Policy of 2002-2004 increased
demand for, and price of, housing. The low short-term interest rates made adjustable rate loans with low down payments highly attractive. As the Fed pushed short-term interest rates upward in 2005-2006, adjustable rates were soon reset, monthly payment on these loans increased, housing prices began to fall, and defaults soared.

What Caused the Crisis of 2008?

FACTOR 3: An SEC Rule change adopted in April 2004 led to highly leverage lending practices by investment banks and their quick demise when default rates increased.
The rule favored lending for residential housing. Loans for residential housing could be leveraged by as much as 25 to 1, and as much as 60 to 1, when bundled together and financed with securities. Based on historical default rates, mortgage loans for residential housing were thought to be safe. But this was no longer true because regulations had seriously eroded the lending standards and the low interest rates of 2002-2004 had increased the share of ARM loans with little or no down payment. When default rates increased in 2006 and 2007, the highly leveraged investment banks soon collapsed.

What Caused the Crisis of 2008?

FACTOR 4: Doubling of the Debt/Income Ratio of Households since the mid-1980s.
The debt-to-income ratio of households was generally between 45 and 60 percent for several decades prior to the mid 1980s. By 2007, the debt-toincome ratio of households had increased to 135 percent. Interest on household debt also increased substantially. Because interest on housing loans was tax deductible, households had an incentive to wrap more of their debt into housing loans. The heavy indebtedness of households meant they had no leeway to deal with unexpected expenses or rising mortgage payments.