Describe the progress of global financial crisis which was arising in US in 2008 and analyze root causes of this crisis

rial 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 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 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. 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 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%  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 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, 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. Mortgage-backed security In recent years, the banks have found new ways of lending to people wishing to buy a house whilst removing 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 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 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. 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 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 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 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 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. 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. 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 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 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. 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 mid-2009.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. 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 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.Top of Form Nationalization of financial institutions 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”. 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 “non-routine” 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 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. Lessons from the crisis 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. 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 effected. 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. Conclusion The world financial crisis left a lot of serious problems for the whole world economy. No one could predict its ravage before, and when the crisis happen, it made a strong impact on many aspects of the economy: collapse of major investment banks, funds became risky, credit well dried up; and most important, collapse of confidence make the world economy – which is considered very stable before – suddenly became fragile. Governments around the world – with their own efforts – published many policies to help the economy escape from disaster, and also bolster citizens and investor’s confidence in a stable recover of the economy. After the recession which is happen around the world, there are many lessons for us to learn. The policy makers now must seriously think about the long-run policies instead of simple short-run policies, and, of course, reinvent the monetary and fiscal system. Banks and other institutions should creat a safer model of deposit and mortgage debt to replace the old one. National Economics University Mid-term Assignment Describe the progress of global financial crisis which was arising in US in 2008 and analyze root causes of this crisis Student: Dong Manh Cuong Class : Advanced Finance A – K51 Hanoi, 2010 ._.