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Introduction
The 2008 financial crisis which is sweeping across the
world economy has left serious damage for many countries,
from the United State to the Europe, other industrial
countries,
emerging
markets,
and
developing
Asia.
Especially, in its epicenter – the USA – financial system was
nearly crumbled because of the weakness and shortcoming
of monetary and financial policies. In 29 September 2008,
the stock market saw the largest single-day loss in the
history of the DJIA (Dow Jones Industrial Average) with a
loss of 778 points. In a short time, the global economy is
threatened by a deep recession with the collapse of major
investment banks, mortgage loan institutions and the panic
that covered the whole of global equity markets.
Commercial paper which is usually considered as a safe
investment by money market funds, suddenly became risky.
A collapse of confidence became unpreventable and global
credit condition froze. Credit became impossibly expensive,
interest approached zero, loan windows suddenly were
slammed shut… In this paper, we will discuss about the
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causes and impacts of this crisis to the global economy; from
that point, proposing methods to solve problems in the
present and for future.
Causes
The crisis can be attributed to a number of factors: the
inability of homeowners to make their mortgage payments,
adjustable-rate
mortgages
resetting,
speculation
and
overbuilding during the boom period, risky mortgage
products, high personal and corporate debt levels, financial
products that distributed and perhaps concealed the risk of
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mortgage default, bad monetary and housing policies,
international trade imbalances,… But it has its roots in real
estate and the subprime lending crisis. The following are
some main factors that caused that terrible crisis.
1. Easy money policy
In 2000s, despite soaring commodity prices and a falling
dollar, which would normally raise inflation fears, the Fed
has eased monetary policy, reducing its target for the federal
funds rate from 5.25% (from 2006) to 2.25%. In the process
of reaching the lower interest rate target, the Fed buys
securities from depository institutions, giving them new cash
to lend and of course, lower rates stimulate demand for
credit. Additional, because of the trade deficit, the U.S. must
borrowed money from abroad, which bid up bond prices and
lowered interest rates. Between 1996 to 2004, the USA trade
deficit increased by $650 billion. To solve this problem, the
government must borrowed large sums of capital from
abroad. When these funds reached the USA, the market have
too much capital and with the easy credit condition, USA
household used it to finance consumption or to bid up the
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price of housing and other assets; meanwhile, financial
institutions invested foreign capital in mortgage-backed
securities.
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.
16%
14%
12%
10%
8%
6%
4%
2%
0%
-2%
-4%
6
%
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1995 1996 1997 1998 1999 2000 2001 2002
2003 2004 2005 2006 2007 2008
FDI Liabilities
Equity Liabilities
Debt
Liabilities Other Liabilities
Total
Figure 9: Composition of U.S. Gross Capital Inflows.
Source: BEA. Percent of U.S. GDP
2. Subprime lending crisis
Another reason lead us to the crisis is subprime lending.
It’s a special kind of loan that attracted many homeowners
with less than perfect credit, they can borrow more than they
can afford – an adjustable rate mortgage (ARM). These
mortgages often come with a low interest rate that makes the
loan seem cheap. However, after a certain period of time, the
loan’s interest rate was adjusted to a much higher rate (often
higher than the borrower can afford to pay).
In 2005, home prices were higher than they’d ever been.
Real estate was the hot, “sure thing” investment. Home
buyers had no problem signing an ARM, because they
assumed that as the price of their home continued to rise,
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they could either refinance or flip the house before the
higher interest rates kicked in. But when the housing bubble
burst, housing price fell dramatically. By this time, all those
ARMs signed are beginning to adjust to much higher interest
rates. Faced with payments far too high for their budgets,
people normally would sell the house and “buyout” the
mortgage with the proceeds. However, real estate prices are
lower than they were – meaning that selling the home would
not net nearly enough to cover the amount of the mortgage
and of course, homeowners became default. When
homeowners default on their loans, banks do the only thing
they can to recover their money – seize the property pledged
as collateral (the home). However, this did not solve the
problem because the housing prices were far lower than
before. The result has been a large decline in the capital of
many banks and U.S. government sponsored enterprises,
tightening credit around the world.
3. Mortgage-backed security
In recent years, the banks have found new ways of
lending to people wishing to buy a house whilst removing
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the risk of a person defaulting on a mortgage from their own
balance sheets. This new model of lending made credit both
cheaper and easier. In some senses this sub-prime lending is
a sort of financial inclusion, introducing the aspirational
poor to “home ownership” for the first time with the
attendant feeling of wealth that emerges as house prices
increase.
Mortgages were turned into bonds for sale with the
approval of risk rating agencies which were less independent
than they ought to have been since they were paid by the
banks whose bonds they were issuing. These bonds were
called Mortgage-backed securities (MBS). The problem
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occurred when the housing market fell in the United States,
home owners began defaulting on their mortgages and
people realized that MBS were not going to be worth as
much as they had thought. Because banks had also found
ways of holding mortgage bonds off their balance sheets,
another problem emerged - no one knew who was holding
the bad bonds. The result is that banks are suspicious of each
other and will not lend to each other for fear of the borrower
having hidden liabilities. More serious, when real estate
contracts which ensure for MBS became a bad loans, MBS
prices fell dramatically in the market. Thus, banks and
investors who held a large amount of MBS default and go
bankrupt.
Fannie Mae and Freddie Mac are two government
agencies who created, and remain highly involved in, the
secondary market for mortgage-backed securities. In 2007,
they owned about $1.4 trillion, or 40%, of all U.S.
mortgages, with $168 billion in subprime mortgages. Fannie
Mae and Freddie Mac's problems began in the U.S. real
estate bubble of the early 2000s. From 2004-2006, Fannie
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Mae and Freddie Mac purchased $434 billion in securities
backed by subprime loans, further fueling the boom in
subprime lending. When the housing bubble burst Fannie
Mae and Freddie Mac recorded $14.9 billion in combined
net losses in 2007, depleting their capital and undermining
their financial strength. Fannie Mae already down 83% for
the year and Freddie Mac down 88% on concerns about their
solvency. The crisis with Fannie Mae and Freddie Mac
brought the gravity of the situation home to investors around
the world, as far as the subprime mortgage market and U.S.
housing were concerned. To deal with this problem, in 2008,
the USA government decided to takeover Fannie Mae &
Freddie Mac.
4. The housing market declined
Between 1997 and 2006, the price of the typical American
house increased by 124%. While housing prices were
increasing, consumers were saving less and both borrowing
and spending more. Household debt grew from $705 billion
in 1974 to $7.4 trillion in 2000 and finally to $14.5 trillion in
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midyear 2008. 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.
Easy credit and a belief that house prices would
continue increase, encouraged many borrowers obtain
ARMs. And with this kind of mortgage, refinancing became
very difficult, thus, once house prices began to decline
borrowers began to default. When the crisis broke out, more
borrowers
stop
paying
their
mortgage
payments,
foreclosures and number of homes for sale increased day by
day. By September 2008, average housing price had reduced
over 20% from their 2006 peak. This unexpected decrease of
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housing prices means that the borrowers home were worth
less than their mortgage and they have nothing in their
home. And, of course, this house would be confiscated by
the lender.
Increasing foreclosure rates increases the inventory of
houses offered for sale. In the crisis time, we can saw the
notice-board “house for sale” everywhere in the USA. A lot
of unsold homes lowered house prices. As prices reduced,
more homeowners were risky of default and foreclosure.
Impacts
I. Impacts on the USA
Between June 2007 and November 2008, Americans lost
more than a quarter of their 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 3035% potential drop. Total home equity in the United States,
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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. The banking industry has been badly hit as many of
the mortgage bonds backed by sub-prime mortgages have
fallen in value. As a result of the bad debts banks became
reluctant to lend and this led to a credit crunch. A slow
down in the building industry which contributes 15 percent
to US output has had a ripple effect on other industries
especially makers of durable goods.
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According to the IMF, owing to financial crisis, the US
economic growth should drop to 0.1% in 2009. The US bank
announced the elimination of 52,000 positions.
Ranked among the world's top investment banks, the
Lehman Brothers also fell into trouble. The sub-prime crisis
with the decline in value of housing forced the company to
take huge write downs on the value of those assets and led to
the loss of about US$14 billion. This further led to Lehman’s
prime customers pulling out their monies into much safer
investment avenues e.g. investing in government bonds. This
contributed to the company’s filing for bankruptcy
protection and hence its fall. The collapse of the company
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put tens of thousands of jobs around the world at risk. The
impact was also huge in other major economies considering
the integration of the financial markets and the global nature
of business today
II. Impacts on the world economy
The world economy is rapidly affected by the financial
crisis,
with
its
social
impact
related
to
increased
unemployment. For the coming year after crisis, the world
GDP growth rate for the developing countries was projected
around 6.4 percent. In late October 2008, about $25,000
billion disappeared in the global stock market tumble. For
the first time in several years, Latin America should expect a
deficit in the balance of payments. Moreover, GDP growth
for the whole region could also fall in 2009. In Mexico,
remittances of earnings from the expatriates have already
decreased and the central bank is being forced to support the
Mexican peso. Foreign exchange reserves have shrunken
immensely. The Brazilian stock market index registered a
substantial fall and major investment projects were
postponed.
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China, the locomotive engine of the world economy has
begun to tumble. The tremors of financial crisis have felt
seriously in China now and the experts have forecast a lower
GDP growth rate for coming years. In addition, the exports
of China to the United States, which accounts 20% of its
total exports, have been projected below 8% for 2009.
Asian internal trade is likely to deteriorate because of
declining demand from China.
Japan is threatened with a return of deflation from mid2009.The economic out look for Germany is also not very
much promising. Germany, the first euro-area economy will
experience a recession for the whole of 2009, with GDP
declining
by
0.8%.
The international financial crisis should also plunged France
into recession in 2009. With a GDP decline of 0.4%,
significantly widening the public deficit. While the UK will
also sink into recession in the full year next year. Taken
together, the 30 OECD countries should experience a
recession of 0.4% next year, then a recovery of 1.5% in
2010, according to an estimate.
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In July 2008, a barrel of crude oil cost $147 and on the
November 20, it sold for $58. The drastic cuts in production
(-1.5 million barrels per day) announced by the OPEC
countries have failed to reverse the trend. This is a real
challenge for countries like Ecuador, Iran, Venezuela and
Russia who base their policies on high oil prices.
Solutions and lessons from the world financial crisis
I. Solutions of some main countries to escape from the
crisis
Now we will see how governments around the world coped
with difficulties to avoid a financial disaster.
1. Nationalization of financial institutions
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The Treasury Department of USA took over the
Freddie and Fannie in the mess and injected capitals by the
form of purchasing relative preferred stock to both of them.
American Federal Reserve Committee offered emergency
loans to AIG. And the government of USA began to charge
the large financial assets. The government of British
declared a bank rescue project with the core of
nationalization, and infected capitals to various commercial
banks by the form of “bank capital regulatory funds”.
2.
Reduction of interest
Seven largest central banks in the world declared
the reduction of interest simultaneously. The central bank
of Australia first reduced the interest in the past seven
years, and the interest had achieved the lowest level since
Dec of 2006. These reductions of interest were all “nonroutine” reductions, because the interest reductions were
not declared in the routine meeting of the central bank.
3. Deposit guarantee
Various governments in Europe established protective
measures of individual deposit with different scales
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successively to guarantee the benefit of depositors. Various
countries in EU also adopted similar measures. The region
of Taiwan promise guarantying all personal bank deposits.
Singapore guaranteed all deposits including SGD and
foreign currency for all individuals and enterprises.
4. Injecting capitals to the financial market
Many central banks frequently injected capitals to the
financial market with intense liquidity. Especially after
Lehman Brother went bankruptcy, the injections of various
countries became more active.
5. Cooperation of many countries
American Federal Reserve Committee had achieved the
currency exchange agreement with the central banks of
Europe, Japan, British, Switzerland and Canada to release
the shortage of liquidity in the financial market. China had
established the “Asian Mutual Funds” with Japan and
Korea to prevent the damage of “taking money and
running” to the currency system by holding the others’
money as the exchange reserves.
II. Lessons from the crisis
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From this financial crisis, we recognize a lot of lessons
about the weakness and shortcoming not only in the
financial system but also in administration. In the following,
I will list some main lessons for the world economy.
1.
Interconnectedness
This financial crisis showed us how important the
interconnections are among the banking system, capital
markets, payment and settlement systems. For example, the
disruption of the securitization markets caused by the poor
performance of highly-rated debt securities, led to
significant problems for major financial institutions. Banks
had to take assets back on their books; backstop lines of
credit were triggered; and banks could no longer securitize
loans, increasing the pressure on their balance sheets. This
reduced credit availability, which increased the downward
pressure on economic activity, which caused asset values to
decline further, increasing the degree of stress in the
financial system. Factors in the system related with each
other and when we act on one factor, all of them would be
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effected.
2.
Lack of obviousness
The most important lesson we have learned in this crisis
is the lack of obviousness. There were many areas where a
lack of obviousness contributed to a loss of confidence,
which intensified the crisis.
A. Valuation. CDOs and other securitized obligations were
complex and difficult to value. This reduced liquidity,
pushed down prices and created increased uncertainty about
the solvency of institutions holding these assets.
B. Prices. The lack of pricing information led to a loss of
confidence about accounting marks. Sometimes identical
securities were valued differently at different financial
institutions.
C. Concentration of risk. Because there was no detailed
reporting of exposures, market participants did not know
much about the concentration of risk. This led to a
reluctance to engage with counterparties, which pushed up
spreads and reduced liquidity further.
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