2006 financial crisis
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2006 financial crisis

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Treasury bonds early in the decade. This pool of money had roughly doubled in size from to , yet the supply of relatively safe, income generating investments had not grown as fast. Investment banks on Wall Street answered this demand with products such as the mortgage-backed security and the collateralized debt obligation that were assigned safe ratings by the credit rating agencies.

In effect, Wall Street connected this pool of money to the mortgage market in the US, with enormous fees accruing to those throughout the mortgage supply chain , from the mortgage broker selling the loans to small banks that funded the brokers and the large investment banks behind them. By approximately , the supply of mortgages originated at traditional lending standards had been exhausted, and continued strong demand began to drive down lending standards.

The collateralized debt obligation in particular enabled financial institutions to obtain investor funds to finance subprime and other lending, extending or increasing the housing bubble and generating large fees. This essentially places cash payments from multiple mortgages or other debt obligations into a single pool from which specific securities draw in a specific sequence of priority. Those securities first in line received investment-grade ratings from rating agencies.

Securities with lower priority had lower credit ratings but theoretically a higher rate of return on the amount invested. By September , average U. During , lenders began foreclosure proceedings on nearly 1. After the bubble burst, Australian economist John Quiggin wrote, "And, unlike the Great Depression, this crisis was entirely the product of financial markets.

There was nothing like the postwar turmoil of the s, the struggles over gold convertibility and reparations, or the Smoot-Hawley tariff , all of which have shared the blame for the Great Depression. Lower interest rates encouraged borrowing. From to , the Federal Reserve lowered the federal funds rate target from 6. Additional downward pressure on interest rates was created by rising U. Federal Reserve chairman Ben Bernanke explained how trade deficits required the U.

Bernanke explained that between and , the U. Financing these deficits required the country to borrow large sums from abroad, much of it from countries running trade surpluses. These were mainly the emerging economies in Asia and oil-exporting nations. The balance of payments identity requires that a country such as the US 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 U. All of this created demand for various types of financial assets, raising the prices of those assets while lowering interest rates. Ben Bernanke referred to this as a " saving glut ". A flood of funds capital or liquidity reached the U. Foreign governments supplied funds by purchasing Treasury bonds and thus avoided much of the direct effect of the crisis.

Financial institutions invested foreign funds in mortgage-backed securities. The Fed then raised the Fed funds rate significantly between July and July Subprime lending standards declined in the U. By , many lenders dropped the required FICO score to , making it much easier to qualify for prime loans and making subprime lending a riskier business. Proof of income and assets were de-emphasized. Loans at first required full documentation, then low documentation, then no documentation.

One subprime mortgage product that gained wide acceptance was the no income, no job, no asset verification required NINJA mortgage. Informally, these loans were aptly referred to as " liar loans " because they encouraged borrowers to be less than honest in the loan application process. Bowen III , on events during his tenure as the Business Chief Underwriter for Correspondent Lending in the Consumer Lending Group for Citigroup , where he was responsible for over professional underwriters, suggests that by and , the collapse of mortgage underwriting standards was endemic.

Moreover, during , "defective mortgages from mortgage originators contractually bound to perform underwriting to Citi's standards increased Predatory lending refers to the practice of unscrupulous lenders, enticing borrowers to enter into "unsafe" or "unsound" secured loans for inappropriate purposes.

In June , Countrywide Financial was sued by then California Attorney General Jerry Brown for "unfair business practices" and "false advertising", alleging that Countrywide used "deceptive tactics to push homeowners into complicated, risky, and expensive loans so that the company could sell as many loans as possible to third-party investors".

This caused Countrywide's financial condition to deteriorate, ultimately resulting in a decision by the Office of Thrift Supervision to seize the lender. One Countrywide employee—who would later plead guilty to two counts of wire fraud and spent 18 months in prison—stated that, "If you had a pulse, we gave you a loan. Former employees from Ameriquest , which was United States' leading wholesale lender, described a system in which they were pushed to falsify mortgage documents and then sell the mortgages to Wall Street banks eager to make fast profits.

There is growing evidence that such mortgage frauds may be a cause of the crisis. According to Barry Eichengreen, the roots of the financial crisis lay in the deregulation of financial markets. In other cases, laws were changed or enforcement weakened in parts of the financial system. Key examples include:. A paper suggested that Canada's avoidance of a banking crisis in as well as in prior eras could be attributed to Canada possessing a single, powerful, overarching regulator, while the United States had a weak, crisis prone and fragmented banking system with multiple competing regulatory bodies.

Prior to the crisis, financial institutions became highly leveraged, increasing their appetite for risky investments and reducing their resilience in case of losses. Much of this leverage was achieved using complex financial instruments such as off-balance sheet securitization and derivatives, which made it difficult for creditors and regulators to monitor and try to reduce financial institution risk levels.

From to , the top five U. Changes in capital requirements, intended to keep U. The shift from first-loss tranches to AAA-rated tranches was seen by regulators as a risk reduction that compensated the higher leverage. Lehman Brothers went bankrupt and was liquidated , Bear Stearns and Merrill Lynch were sold at fire-sale prices, and Goldman Sachs and Morgan Stanley became commercial banks, subjecting themselves to more stringent regulation.

With the exception of Lehman, these companies required or received government support. Fannie Mae and Freddie Mac, two U. Behavior that may be optimal for an individual such as saving more during adverse economic conditions, can be detrimental if too many individuals pursue the same behavior, as ultimately one person's consumption is another person's income. Too many consumers attempting to save or pay down debt simultaneously is called the paradox of thrift and can cause or deepen a recession.

Economist Hyman Minsky also described a "paradox of deleveraging" as financial institutions that have too much leverage debt relative to equity cannot all de-leverage simultaneously without significant declines in the value of their assets. Once this massive credit crunch hit, it didn't take long before we were in a recession.

The recession, in turn, deepened the credit crunch as demand and employment fell, and credit losses of financial institutions surged. Indeed, we have been in the grips of precisely this adverse feedback loop for more than a year. A process of balance sheet deleveraging has spread to nearly every corner of the economy.

Consumers are pulling back on purchases, especially on durable goods, to build their savings. Businesses are cancelling planned investments and laying off workers to preserve cash. And, financial institutions are shrinking assets to bolster capital and improve their chances of weathering the current storm. Once again, Minsky understood this dynamic.

He spoke of the paradox of deleveraging, in which precautions that may be smart for individuals and firms—and indeed essential to return the economy to a normal state—nevertheless magnify the distress of the economy as a whole. 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 subprime 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.

As described in the section on subprime lending, the CDS and portfolio of CDS called synthetic CDO enabled a theoretically infinite amount to be wagered on the finite value of housing loans outstanding, provided that buyers and sellers of the derivatives could be found. This boom in innovative financial products went hand in hand with more complexity.

It multiplied the number of actors connected to a single mortgage including mortgage brokers, specialized originators, the securitizers and their due diligence firms, managing agents and trading desks, and finally investors, insurances and providers of repo funding. With increasing distance from the underlying asset these actors relied more and more on indirect information including FICO scores on creditworthiness, appraisals and due diligence checks by third party organizations, and most importantly the computer models of rating agencies and risk management desks.

Instead of spreading risk this provided the ground for fraudulent acts, misjudgments and finally market collapse. Martin Wolf , chief economics commentator at the Financial Times , wrote in June that certain financial innovations enabled firms to circumvent regulations, such as off-balance sheet financing that affects the leverage or capital cushion reported by major banks, stating: " Mortgage risks were underestimated by almost all institutions in the chain from originator to investor by underweighting the possibility of falling housing prices based on historical trends of the past 50 years.

Limitations of default and prepayment models, the heart of pricing models, led to overvaluation of mortgage and asset-backed products and their derivatives by originators, securitizers, broker-dealers, rating-agencies, insurance underwriters and the vast majority of investors with the exception of certain hedge funds. The pricing of risk refers to the risk premium required by investors for taking on additional risk, which may be measured by higher interest rates or fees.

Several scholars have argued that a lack of transparency about banks' risk exposures prevented markets from correctly pricing risk before the crisis, enabled the mortgage market to grow larger than it otherwise would have, and made the financial crisis far more disruptive than it would have been if risk levels had been disclosed in a straightforward, readily understandable format. For a variety of reasons, market participants did not accurately measure the risk inherent with financial innovation such as MBS and CDOs or understand its effect on the overall stability of the financial system.

AIG insured obligations of various financial institutions through the usage of credit default swaps. However, AIG did not have the financial strength to support its many CDS commitments as the crisis progressed and was taken over by the government in September It concluded in January The Commission concludes AIG failed and was rescued by the government primarily because its enormous sales of credit default swaps were made without putting up the initial collateral, setting aside capital reserves, or hedging its exposure—a profound failure in corporate governance, particularly its risk management practices.

AIG's failure was possible because of the sweeping deregulation of over-the-counter OTC derivatives, including credit default swaps, which effectively eliminated federal and state regulation of these products, including capital and margin requirements that would have lessened the likelihood of AIG's failure. The limitations of a widely used financial model also were not properly understood. Because it was highly tractable, it rapidly came to be used by a huge percentage of CDO and CDS investors, issuers, and rating agencies.

Then the model fell apart. Cracks started appearing early on, when financial markets began behaving in ways that users of Li's formula hadn't expected. The cracks became full-fledged canyons in —when ruptures in the financial system's foundation swallowed up trillions of dollars and put the survival of the global banking system in serious peril Li's Gaussian copula formula will go down in history as instrumental in causing the unfathomable losses that brought the world financial system to its knees.

As financial assets became more complex and harder to value, investors were reassured by the fact that the international bond rating agencies and bank regulators accepted as valid some complex mathematical models that showed the risks were much smaller than they actually were.

Similarly, the rating agencies relied on the information provided by the originators of synthetic products. It was a shocking abdication of responsibility. A conflict of interest between investment management professional and institutional investors , combined with a global glut in investment capital, led to bad investments by asset managers in over-priced credit assets. Professional investment managers generally are compensated based on the volume of client assets under management.

There is, therefore, an incentive for asset managers to expand their assets under management in order to maximize their compensation. As the glut in global investment capital caused the yields on credit assets to decline, asset managers were faced with the choice of either investing in assets where returns did not reflect true credit risk or returning funds to clients. Many asset managers continued to invest client funds in over-priced under-yielding investments, to the detriment of their clients, so they could maintain their assets under management.

They supported this choice with a "plausible deniability" of the risks associated with subprime-based credit assets because the loss experience with early "vintages" of subprime loans was so low. Despite the dominance of the above formula, there are documented attempts of the financial industry, occurring before the crisis, to address the formula limitations, specifically the lack of dependence dynamics and the poor representation of extreme events.

See also the article by Donnelly and Embrechts [] and the book by Brigo, Pallavicini and Torresetti, that reports relevant warnings and research on CDOs appeared in There is strong evidence that the riskiest, worst performing mortgages were funded through the " shadow banking system " and that competition from the shadow banking system may have pressured more traditional institutions to lower their underwriting standards and originate riskier loans.

In a June speech, President and CEO of the Federal Reserve Bank of New York Timothy Geithner —who in became United States Secretary of the Treasury —placed significant blame for the freezing of credit markets on a "run" on the entities in the "parallel" banking system, also called the shadow banking system. These entities became critical to the credit markets underpinning the financial system, but were not subject to the same regulatory controls.

Further, these entities were vulnerable because of Asset—liability mismatch , meaning that they borrowed short-term in liquid markets to purchase long-term, illiquid and risky assets. This meant that disruptions in credit markets would force them to engage in rapid deleveraging, selling their long-term assets at depressed prices. He described the significance of these entities:. The combined effect of these factors was a financial system vulnerable to self-reinforcing asset price and credit cycles.

Economist Paul Krugman , laureate of the Nobel Memorial Prize in Economic Sciences , described the run on the shadow banking system as the "core of what happened" to cause the crisis. He referred to this lack of controls as "malign neglect" and argued that regulation should have been imposed on all banking-like activity. This meant that nearly one-third of the U. While traditional banks raised their lending standards, it was the collapse of the shadow banking system that was the primary cause of the reduction in funds available for borrowing.

The securitization markets supported by the shadow banking system started to close down in the spring of and nearly shut-down in the fall of More than a third of the private credit markets thus became unavailable as a source of funds. In a paper, Ricardo J. Caballero , Emmanuel Farhi , and Pierre-Olivier Gourinchas argued that the financial crisis was attributable to "global asset scarcity, which led to large capital flows toward the United States and to the creation of asset bubbles that eventually burst.

That is, the global economy was subject to one shock with multiple implications rather than to two separate shocks financial and oil. The empirical research has been mixed. In a book, John McMurtry suggested that a financial crisis is a systemic crisis of capitalism itself. In his book, The Downfall of Capitalism and Communism , Ravi Batra suggests that growing inequality of financial capitalism produces speculative bubbles that burst and result in depression and major political changes.

He also suggested that a "demand gap" related to differing wage and productivity growth explains deficit and debt dynamics important to stock market developments. John Bellamy Foster , a political economy analyst and editor of the Monthly Review , believed that the decrease in GDP growth rates since the early s is due to increasing market saturation.

Marxian economics followers Andrew Kliman , Michael Roberts, and Guglielmo Carchedi, in contradistinction to the Monthly Review school represented by Foster, pointed to capitalism's long-term tendency of the rate of profit to fall as the underlying cause of crises generally. From this point of view, the problem was the inability of capital to grow or accumulate at sufficient rates through productive investment alone.

Low rates of profit in productive sectors led to speculative investment in riskier assets, where there was potential for greater return on investment. The speculative frenzy of the late 90s and s was, in this view, a consequence of a rising organic composition of capital, expressed through the fall in the rate of profit.

According to Michael Roberts, the fall in the rate of profit "eventually triggered the credit crunch of when credit could no longer support profits". Bogle wrote that "Corporate America went astray largely because the power of managers went virtually unchecked by our gatekeepers for far too long". Echoing the central thesis of James Burnham 's seminal book, The Managerial Revolution , Bogle cites issues, including: [].

Roeder suggested that "recent technological advances, such as computer-driven trading programs, together with the increasingly interconnected nature of markets, has magnified the momentum effect. This has made the financial sector inherently unstable. This stagnation forced the population to borrow to meet the cost of living. A report by the International Labour Organization concluded that cooperative banking institutions were less likely to fail than their competitors during the crisis.

Economists, particularly followers of mainstream economics , mostly failed to predict the crisis. Popular articles published in the mass media have led the general public to believe that the majority of economists have failed in their obligation to predict the financial crisis. For example, an article in The New York Times noted that economist Nouriel Roubini warned of such crisis as early as September , and stated that the profession of economics is bad at predicting recessions.

Rose and Mark M. The authors examined various economic indicators, ignoring contagion effects across countries. The authors concluded: "We include over sixty potential causes of the crisis, covering such categories as: financial system policies and conditions; asset price appreciation in real estate and equity markets; international imbalances and foreign reserve adequacy; macroeconomic policies; and institutional and geographic features.

Despite the fact that we use a wide number of possible causes in a flexible statistical framework, we are unable to link most of the commonly cited causes of the crisis to its incidence across countries. This negative finding in the cross-section makes us skeptical of the accuracy of 'early warning' systems of potential crises, which must also predict their timing.

The Austrian School regarded the crisis as a vindication and classic example of a predictable credit-fueled bubble caused by laxity in monetary supply. Several followers of heterodox economics predicted the crisis, with varying arguments. Shiller, a founder of the Case-Shiller index that measures home prices, wrote an article a year before the collapse of Lehman Brothers in which he predicted that a slowing U.

Karim Abadir, based on his work with Gabriel Talmain, [] predicted the timing of the recession [] whose trigger had already started manifesting itself in the real economy from early There were other economists that did warn of a pending crisis. In , at a celebration honoring Alan Greenspan , who was about to retire as chairman of the US Federal Reserve , Rajan delivered a controversial paper that was critical of the financial sector.

These risks are known as tail risks. But perhaps the most important concern is whether banks will be able to provide liquidity to financial markets so that if the tail risk does materialize, financial positions can be unwound and losses allocated so that the consequences to the real economy are minimized. Stock trader and financial risk engineer Nassim Nicholas Taleb , author of the book The Black Swan , spent years warning against the breakdown of the banking system in particular and the economy in general owing to their use of and reliance on bad risk models and reliance on forecasting, and framed the problem as part of "robustness and fragility".

The first visible institution to run into trouble in the United States was the Southern California—based IndyMac , a spin-off of Countrywide Financial. Before its failure, IndyMac Bank was the largest savings and loan association in the Los Angeles market and the seventh largest mortgage loan originator in the United States. The primary causes of its failure were largely associated with its business strategy of originating and securitizing Alt-A loans on a large scale.

This strategy resulted in rapid growth and a high concentration of risky assets. From its inception as a savings association in , IndyMac grew to the seventh largest savings and loan and ninth largest originator of mortgage loans in the United States.

IndyMac's aggressive growth strategy, use of Alt-A and other nontraditional loan products, insufficient underwriting, credit concentrations in residential real estate in the California and Florida markets—states, alongside Nevada and Arizona, where the housing bubble was most pronounced—and heavy reliance on costly funds borrowed from a Federal Home Loan Bank FHLB and from brokered deposits, led to its demise when the mortgage market declined in IndyMac often made loans without verification of the borrower's income or assets, and to borrowers with poor credit histories.

Appraisals obtained by IndyMac on underlying collateral were often questionable as well. Ultimately, loans were made to many borrowers who simply could not afford to make their payments. The thrift remained profitable only as long as it was able to sell those loans in the secondary mortgage market. IndyMac resisted efforts to regulate its involvement in those loans or tighten their issuing criteria: see the comment by Ruthann Melbourne, Chief Risk Officer, to the regulating agencies.

On May 12, , in the "Capital" section of its last Q, IndyMac revealed that it may not be well capitalized in the future. IndyMac concluded that these downgrades would have harmed its risk-based capital ratio as of June 30, Had these lowered ratings been in effect at March 31, , IndyMac concluded that the bank's capital ratio would have been 9. IndyMac was taking new measures to preserve capital, such as deferring interest payments on some preferred securities.

Dividends on common shares had already been suspended for the first quarter of , after being cut in half the previous quarter. The company still had not secured a significant capital infusion nor found a ready buyer. The letter outlined the Senator's concerns with IndyMac.

While the run was a contributing factor in the timing of IndyMac's demise, the underlying cause of the failure was the unsafe and unsound way it was operated. On June 26, , Senator Charles Schumer D-NY , a member of the Senate Banking Committee , chairman of Congress' Joint Economic Committee and the third-ranking Democrat in the Senate, released several letters he had sent to regulators, in which he was"concerned that IndyMac's financial deterioration poses significant risks to both taxpayers and borrowers.

IndyMac announced the closure of both its retail lending and wholesale divisions, halted new loan submissions, and cut 3, jobs. Until then, depositors would have access their insured deposits through ATMs, their existing checks, and their existing debit cards. Telephone and Internet account access was restored when the bank reopened. IndyMac Bancorp filed for Chapter 7 bankruptcy on July 31, 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 mortgage lenders went bankrupt during and The financial institution crisis hit its peak in September and October Several major institutions either failed, were acquired under duress, or were subject to government takeover. Fuld Jr. Fuld said he was a victim of the collapse, blaming a "crisis of confidence" in the markets for dooming his firm. The initial articles and some subsequent material were adapted from the Wikinfo article Financial crisis of — released under the GNU Free Documentation License Version 1.

From Wikipedia, the free encyclopedia. Worldwide economic crisis. Causes of the European debt crisis Causes of the United States housing bubble Credit rating agencies and the subprime crisis Government policies and the subprime mortgage crisis. Summit meetings.

Government response and policy proposals. Business failures. See also: Global financial crisis in September , Global financial crisis in October , Global financial crisis in November , Global financial crisis in December , Global financial crisis in , United States bear market of — , Dodd-Frank Wall Street Reform and Consumer Protection Act , Regulatory responses to the subprime crisis , and Subprime mortgage crisis solutions debate.

See also: Subprime crisis background information , Subprime crisis impact timeline , Subprime mortgage crisis solutions debate , Indirect economic effects of the subprime mortgage crisis , and Great Recession. Main article: Subprime mortgage crisis. Main article: United States housing bubble. Further information: Government policies and the subprime mortgage crisis. Main article: s commodities boom. Banking Special Provisions Act United Kingdom List of bank failures in the United States —present — Keynesian resurgence United States foreclosure crisis May Day protests Crisis Marxian Kondratiev wave List of banks acquired or bankrupted during the Great Recession List of banks acquired or bankrupted in the United States during the financial crisis of — List of acronyms associated with the eurozone crisis List of economic crises List of entities involved in — financial crises List of largest U.

Knowledge Wharton. Retrieved August 5, Uncontrolled Risk. McGraw-Hill Education. ISBN This American Life. May 9, Journal of Economic Perspectives. ISSN S2CID Financial Crisis". Council on Foreign Relations. January 24, October 22, July Center for Public Integrity. May 6, Dallas Business Journal. Retrieved April 27, Center on Budget and Policy Priorities. PMC PMID Journal of Marriage and Family. Act of Congress No. The United States Congress. October 18, International Monetary Fund.

Business Wire. February 13, July 1, Parallels, Differences and Policy Lessons". Hungarian Academy of Science. SSRN Journal of Advances in Management Research. The Economist. December 11, Encyclopedia Britannica. Retrieved November 24, The Washington Post.

Federal Reserve Board of Governors. Seeking Alpha. April 25, April 23, The New York Times. November 5, The Daily Telegraph. Archived from the original on January 10, April June 15, Brookings Institution. May 22, Los Angeles Times. January Foreign Affairs. Federal Reserve Economic Data. Bureau of Labor Statistics. February Retrieved May 12, This led to a dramatic rise in the number of households living below the poverty line see "The global financial crisis and developing countries: taking stock, taking action" PDF.

Overseas Development Institute. September BBC News. February 14, Federal Deposit Insurance Corporation. Summer Federal Reserve Bank of New York. Centre for Research on Multinational Corporations. Oxford University Press. Democracy Now. Social Science Research Network. Business Insider. Financial Times. Bank for International Settlements. University of Pennsylvania Law Review. The Guardian. The New York Times Magazine. Channel 4. Patent Statistics" PDF.

United States Patent and Trademark Office. CBS News. The Balance. Louis' Financial Crisis Timeline". Vanity Fair. Retrieved January 24, United States Census Bureau. United States Census. May 5, April 3, USA Today. September 8, August 7, June 20, Bank of England. September 14, September 18, Associated Press. September 29, December 12, New York Newsday.

May 20, Pittsburgh Post-Gazette. March 5, June 27, Steel Is on a Roll". Bloomberg News. American Action Network. September 12, The recession was not felt equally around the world; whereas most of the world's developed economies , particularly in North America, South America and Europe, fell into a severe, sustained recession, many more recently developed economies suffered far less impact, particularly China , India and Indonesia , whose economies grew substantially during this period.

Similarly, Oceania suffered minimal impact , in part due to its proximity to Asian markets. Two senses of the word "recession" exist: one sense referring broadly to "a period of reduced economic activity" [8] and ongoing hardship; and the more precise sense used in economics , which is defined operationally , referring specifically to the contraction phase of a business cycle , with two or more consecutive quarters of GDP contraction negative GDP growth rate.

The definition of "great" is amount or intensity considerably above the normal or average and, contrary to some common beliefs, does not infer a positive connotation, merely large in size or scope. Under the academic definition, the recession ended in the United States in June or July We should stop using it.

Recessions are mild dips in the business cycle that are either self-correcting or soon cured by modest fiscal or monetary stimulus. Because of the continuing deflationary trap, it would be more accurate to call this decade's stagnant economy The Lesser Depression or The Great Deflation.

The Great Recession met the IMF criteria for being a global recession only in the single calendar year According to the U. National Bureau of Economic Research the official arbiter of U. The years leading up to the crisis were characterized by an exorbitant rise in asset prices and associated boom in economic demand. US mortgage-backed securities , which had risks that were hard to assess, were marketed around the world, as they offered higher yields than U. Many of these securities were backed by subprime mortgages, which collapsed in value when the U.

The emergence of sub-prime loan losses in began the crisis and exposed other risky loans and over-inflated asset prices. With loan losses mounting and the fall of Lehman Brothers on September 15, , a major panic broke out on the inter-bank loan market. There was the equivalent of a bank run on the shadow banking system , resulting in many large and well established investment banks and commercial banks in the United States and Europe suffering huge losses and even facing bankruptcy, resulting in massive public financial assistance government bailouts.

The global recession that followed resulted in a sharp drop in international trade , rising unemployment and slumping commodity prices. Governments and central banks responded with fiscal policy and monetary policy initiatives to stimulate national economies and reduce financial system risks. The recession renewed interest in Keynesian ' economic ideas on how to combat recessionary conditions. Economists advise that the stimulus measures such as quantitative easing pumping money into the system and holding down central bank wholesale lending interest rate should be withdrawn as soon as economies recover enough to "chart a path to sustainable growth ".

The distribution of household incomes in the United States became more unequal during the post economic recovery. The majority report provided by US Financial Crisis Inquiry Commission , composed of six Democratic and four Republican appointees, reported its findings in January It concluded that "the crisis was avoidable and was caused by:. One of them, signed by three Republican appointees, concluded that there were multiple causes.

He wrote: "When the bubble began to deflate in mid, the low quality and high risk loans engendered by government policies failed in unprecedented numbers. In its "Declaration of the Summit on Financial Markets and the World Economy," dated November 15, , leaders of the Group of 20 cited the following causes:. During a period of strong global growth, growing capital flows, and prolonged stability earlier this decade, market participants sought higher yields without an adequate appreciation of the risks and failed to exercise proper due diligence.

At the same time, weak underwriting standards, unsound risk management practices, increasingly complex and opaque financial products, and consequent excessive leverage combined to create vulnerabilities in the system. Policy-makers, regulators and supervisors, in some advanced countries, did not adequately appreciate and address the risks building up in financial markets, keep pace with financial innovation, or take into account the systemic ramifications of domestic regulatory actions.

He wrote that there were shocks or triggers i. Examples of triggers included: losses on subprime mortgage securities that began in and a run on the shadow banking system that began in mid, which adversely affected the functioning of money markets. Examples of vulnerabilities in the private sector included: financial institution dependence on unstable sources of short-term funding such as repurchase agreements or Repos; deficiencies in corporate risk management; excessive use of leverage borrowing to invest ; and inappropriate usage of derivatives as a tool for taking excessive risks.

Examples of vulnerabilities in the public sector included: statutory gaps and conflicts between regulators; ineffective use of regulatory authority; and ineffective crisis management capabilities. Bernanke also discussed " Too big to fail " institutions, monetary policy, and trade deficits.

There are several "narratives" attempting to place the causes of the recession into context, with overlapping elements. Five such narratives include:. Underlying narratives 1—3 is a hypothesis that growing income inequality and wage stagnation encouraged families to increase their household debt to maintain their desired living standard, fueling the bubble.

Further, this greater share of income flowing to the top increased the political power of business interests, who used that power to deregulate or limit regulation of the shadow banking system. Narrative 5 challenges the popular claim narrative 4 that subprime borrowers with shoddy credit caused the crisis by buying homes they couldn't afford.

This narrative is supported by new research showing that the biggest growth of mortgage debt during the U. The Economist wrote in July that the inflow of investment dollars required to fund the U. That deficit was financed by inflows of foreign savings, in particular from East Asia and the Middle East. Much of that money went into dodgy mortgages to buy overvalued houses, and the financial crisis was the result.

NPR explained this money came from various sources, "[b]ut the main headline is that all sorts of poor countries became kind of rich, making things like TVs and selling us oil. Describing the crisis in Europe, Paul Krugman wrote in February that: "What we're basically looking at, then, is a balance of payments problem, in which capital flooded south after the creation of the euro, leading to overvaluation in southern Europe.

Another narrative about the origin has been focused on the respective parts played by the public monetary policy in the US notably and by the practices of private financial institutions. In the U. Another narrative focuses on high levels of private debt in the US economy. High private debt levels also impact growth by making recessions deeper and the following recovery weaker.

In advanced economies, during the five years preceding , the ratio of household debt to income rose by an average of 39 percentage points, to percent. In Denmark, Iceland, Ireland, the Netherlands, and Norway, debt peaked at more than percent of household income. A surge in household debt to historic highs also occurred in emerging economies such as Estonia, Hungary, Latvia, and Lithuania.

The concurrent boom in both house prices and the stock market meant that household debt relative to assets held broadly stable, which masked households' growing exposure to a sharp fall in asset prices. When house prices declined, ushering in the global financial crisis, many households saw their wealth shrink relative to their debt, and, with less income and more unemployment, found it harder to meet mortgage payments.

Household defaults, underwater mortgages where the loan balance exceeds the house value , foreclosures, and fire sales are now endemic to a number of economies. Household deleveraging by paying off debts or defaulting on them has begun in some countries. It has been most pronounced in the United States, where about two-thirds of the debt reduction reflects defaults. The onset of the economic crisis took most people by surprise.

Federal Reserve Chairman Alan Greenspan said in mid that "at a minimum, there's a little 'froth' [in the U. The Economist , writing at the same time, went further, saying, "[T]he worldwide rise in house prices is the biggest bubble in history". Several analysts, such as Peter Wallison and Edward Pinto of the American Enterprise Institute, have asserted that private lenders were encouraged to relax lending standards by government affordable housing policies.

The legislation gave HUD the power to set future requirements. These rose to 42 percent in and 50 percent in , and by under the G. Bush Administration a 56 percent minimum was established. One of the other challenges with blaming government regulations for essentially forcing banks to make risky loans is the timing.

Blaming affordable housing regulations established in the s for a sudden spike in subprime origination is problematic at best. These banks increased their risk-taking shortly thereafter, significantly increasing their purchases and securitization of lower-quality mortgages, thus encouraging additional subprime and Alt-A lending by mortgage companies.

The Gramm—Leach—Bliley Act , which reduced the regulation of banks by allowing commercial and investment banks to merge, has also been blamed for the crisis, by Nobel Prize -winning economist Joseph Stiglitz among others. Several sources have noted the failure of the US government to supervise or even require transparency of the financial instruments known as derivatives.

Michael Lewis noted CDSs enabled speculators to stack bets on the same mortgage securities. This is analogous to allowing many persons to buy insurance on the same house. Speculators that bought CDS protection were betting significant mortgage security defaults would occur, while the sellers such as AIG bet they would not. An unlimited amount could be wagered on the same housing-related securities, provided buyers and sellers of the CDS could be found.

In , Brooksley E. Born , head of the Commodity Futures Trading Commission , put forth a policy paper asking for feedback from regulators, lobbyists, and legislators on the question of whether derivatives should be reported, sold through a central facility, or whether capital requirements should be required of their buyers. Greenspan, Rubin, and Levitt pressured her to withdraw the paper and Greenspan persuaded Congress to pass a resolution preventing CFTC from regulating derivatives for another six months — when Born's term of office would expire.

Paul Krugman wrote in that the run on the shadow banking system was the fundamental cause of the crisis. Influential figures should have proclaimed a simple rule: anything that does what a bank does, anything that has to be rescued in crises the way banks are, should be regulated like a bank. During , three of the largest U. The investment banks were not subject to the more stringent regulations applied to depository banks.

These failures exacerbated the instability in the global financial system. The remaining two investment banks, Morgan Stanley and Goldman Sachs , potentially facing failure, opted to become commercial banks, thereby subjecting themselves to more stringent regulation but receiving access to credit via the Federal Reserve.

While this money was legally owed to the banks by AIG under agreements made via credit default swaps purchased from AIG by the institutions , a number of Congressmen and media members expressed outrage that taxpayer money was used to bail out banks. Economist Gary Gorton wrote in May Unlike the historical banking panics of the 19th and early 20th centuries, the current banking panic is a wholesale panic, not a retail panic.

In the earlier episodes, depositors ran to their banks and demanded cash in exchange for their checking accounts. Unable to meet those demands, the banking system became insolvent. The current panic involved financial firms "running" on other financial firms by not renewing sale and repurchase agreements repo or increasing the repo margin "haircut" , forcing massive deleveraging, and resulting in the banking system being insolvent.

In the early part of the 20th century, we erected a series of protections — the Federal Reserve as a lender of last resort , federal deposit insurance, ample regulations — to provide a bulwark against the panics that had regularly plagued America's banking system in the 19th century.

Yet, over the past plus years, we permitted the growth of a shadow banking system — opaque and laden with short term debt — that rivaled the size of the traditional banking system. Key components of the market — for example, the multitrillion-dollar repo lending market, off-balance-sheet entities, and the use of over-the-counter derivatives — were hidden from view, without the protections we had constructed to prevent financial meltdowns.

We had a 21st-century financial system with 19th-century safeguards. The financial crisis and the recession have been described as a symptom of another, deeper crisis by a number of economists. For example, Ravi Batra argues that growing inequality of financial capitalism produces speculative bubbles that burst and result in depression and major political changes. They argue that such a reshaping should include new advances within feminist economics and ecological economics that take as their starting point the socially responsible, sensible and accountable subject in creating an economy and economic theories that fully acknowledge care for each other as well as the planet.

The Great Recession had a significant economic and political impact on the United States. While the recession technically lasted from December — June the nominal GDP trough , many important economic variables did not regain pre-recession November or Q4 levels until — A key dynamic slowing the recovery was that both individuals and businesses paid down debts for several years, as opposed to borrowing and spending or investing as had historically been the case.

This shift to a private sector surplus drove a sizable government deficit. Then-Fed Chair Ben Bernanke explained during November several of the economic headwinds that slowed the recovery:. On the political front, widespread anger at banking bailouts and stimulus measures begun by President George W. Bush and continued or expanded by President Obama with few consequences for banking leadership, were a factor in driving the country politically rightward starting in Examples include the rise of the Tea Party and the loss of Democratic majorities in subsequent elections.

President Obama declared the bailout measures started under the Bush administration and continued during his administration as completed and mostly profitable as of December [update]. The crisis in Europe generally progressed from banking system crises to sovereign debt crises, as many countries elected to bail out their banking systems using taxpayer money. Several countries received bailout packages from the troika European Commission, European Central Bank, International Monetary Fund , which also implemented a series of emergency measures.

Many European countries embarked on austerity programs, reducing their budget deficits relative to GDP from to However, with the exception of Germany, each of these countries had public-debt-to-GDP ratios that increased i. This indicates that despite improving budget deficits, GDP growth was not sufficient to support a decline improvement in the debt-to-GDP ratio for these countries during this period. Eurostat reported that the debt to GDP ratio for the 17 Euro area countries together was France had no significant changes, while in Germany and Iceland the unemployment rate declined.

Unemployment varied significantly by country. Economist Martin Wolf analysed the relationship between cumulative GDP growth from to and total reduction in budget deficits due to austerity policies see chart at right in several European countries during April He concluded that: "In all, there is no evidence here that large fiscal contractions [budget deficit reductions] bring benefits to confidence and growth that offset the direct effects of the contractions.

They bring exactly what one would expect: small contractions bring recessions and big contractions bring depressions. Economist Paul Krugman analysed the relationship between GDP and reduction in budget deficits for several European countries in April and concluded that austerity was slowing growth, similar to Martin Wolf. He also wrote: " No wonder, then, that the whole austerity enterprise is spiraling into disaster. Britain's decision to leave the European Union in has been partly attributed to the after-effects of the Great Recession on the country.

While India , Uzbekistan , China , and Iran experienced slowing growth, they did not enter recessions. South Korea narrowly avoided technical recession in the first quarter of Australia avoided a technical recession after experiencing only one quarter of negative growth in the fourth quarter of , with GDP returning to positive in the first quarter of The financial crisis did not affect developing countries to a great extent.

Experts see several reasons: Africa was not affected because it is not fully integrated in the world market. Latin America and Asia seemed better prepared, since they have experienced crises before. In Latin America, for example, banking laws and regulations are very stringent. Bruno Wenn of the German DEG suggests that Western countries could learn from these countries when it comes to regulations of financial markets. The table below displays all national recessions appearing in for the 71 countries with available data , according to the common recession definition, saying that a recession occurred whenever seasonally adjusted real GDP contracts quarter on quarter, through minimum two consecutive quarters.

The few recessions appearing early in are commonly never associated to be part of the Great Recession, which is illustrated by the fact that only two countries Iceland and Jamaica were in recession in Q As of October , only five out of the 71 countries with available quarterly data Cyprus, Italy, Croatia, Belize and El Salvador , were still in ongoing recessions. Iceland fell into an economic depression in following the collapse of its banking system see — Icelandic financial crisis.

The following countries had a recession starting in the fourth quarter of United States, [22]. The following countries had a recession already starting in the first quarter of Latvia, [] Ireland, [] New Zealand, [] and Sweden.

South Korea miraculously avoided recession with GDP returning positive at a 0. Of the seven largest economies in the world by GDP, only China avoided a recession in Japan was in recovery in the middle of the decade s but slipped back into recession and deflation in On February 26, , an Economic Intelligence Briefing was added to the daily intelligence briefings prepared for the President of the United States.

This addition reflects the assessment of U. Business Week stated in March that global political instability is rising fast because of the global financial crisis and is creating new challenges that need managing. If you're in a much longer-run downturn, then all bets are off. Political scientists have argued that the economic stasis triggered social churning that got expressed through protests on a variety of issues across the developing world. In Brazil, disaffected youth rallied against a minor bus-fare hike; [] in Turkey, they agitated against the conversion of a park to a mall [] and in Israel, they protested against high rents in Tel Aviv.

In all these cases, the ostensible immediate cause of the protest was amplified by the underlying social suffering induced by the great recession. In January , the government leaders of Iceland were forced to call elections two years early after the people of Iceland staged mass protests and clashed with the police because of the government's handling of the economy. The rally gathered some 10—20 thousand people. In the evening the rally turned into a Riot.

The crowd moved to the building of the parliament and attempted to force their way into it, but were repelled by the state's police. In late February many Greeks took part in a massive general strike because of the economic situation and they shut down schools, airports, and many other services in Greece.

Asian countries saw various degrees of protest. Beyond these initial protests, the protest movement has grown and continued in In late , the Occupy Wall Street protest took place in the United States, spawning several offshoots that came to be known as the Occupy movement. In the economic difficulties in Spain increased support for secession movements. In Catalonia, support for the secession movement exceeded. On September 11, a pro-independence march drew a crowd that police estimated at 1.

The financial phase of the crisis led to emergency interventions in many national financial systems. As the crisis developed into genuine recession in many major economies, economic stimulus meant to revive economic growth became the most common policy tool. After having implemented rescue plans for the banking system, major developed and emerging countries announced plans to relieve their economies.

In particular, economic stimulus plans were announced in China , the United States , and the European Union. The U. On February 17, , U. This program was referred to as the Homeowner Affordability and Stability Plan. Federal Reserve central bank lowered interest rates and significantly expanded the money supply to help address the crisis.

It plans to hold short-term interest rates near zero even longer, at least until the unemployment rate falls below 6. On September 15, , China cut its interest rate for the first time since Indonesia reduced its overnight rate, at which commercial banks can borrow overnight funds from the central bank, by two percentage points to The stimulus package was invested in key areas such as housing, rural infrastructure, transportation, health and education, environment, industry, disaster rebuilding, income-building, tax cuts, and finance.

Later that month, China's export driven economy was starting to feel the impact of the economic slowdown in the United States and Europe despite the government already cutting key interest rates three times in less than two months in a bid to spur economic expansion. On November 28, , the Ministry of Finance of the People's Republic of China and the State Administration of Taxation jointly announced a rise in export tax rebate rates on some labour-intensive goods.

These additional tax rebates took place on December 1, The stimulus package was welcomed by world leaders and analysts as larger than expected and a sign that by boosting its own economy, China is helping to stabilise the global economy. News of the announcement of the stimulus package sent markets up across the world. However, Marc Faber claimed that he thought China was still in recession on January In Taiwan, the central bank on September 16, , said it would cut its required reserve ratios for the first time in eight years.

In developing and emerging economies, responses to the global crisis mainly consisted in low-rates monetary policy Asia and the Middle East mainly coupled with the depreciation of the currency against the dollar. There were also stimulus plans in some Asian countries, in the Middle East and in Argentina.

Until September , European policy measures were limited to a small number of countries Spain and Italy. In both countries, the measures were dedicated to households tax rebates reform of the taxation system to support specific sectors such as housing. At the beginning of , the UK and Spain completed their initial plans, while Germany announced a new plan. The German government bailed out Hypo Real Estate. The plan comprises three parts. The second part will consist of the state government increasing the capital market within the banks.

From , the United Kingdom began a fiscal consolidation program to reduce debt and deficit levels while at the same time stimulating economic recovery. Most political responses to the economic and financial crisis has been taken, as seen above, by individual nations. Some coordination took place at the European level, but the need to cooperate at the global level has led leaders to activate the G major economies entity.

A first summit dedicated to the crisis took place, at the Heads of state level in November G Washington summit. The G countries met in a summit held on November in Washington to address the economic crisis. Apart from proposals on international financial regulation, they pledged to take measures to support their economy and to coordinate them, and refused any resort to protectionism.

Another G summit was held in London on April Finance ministers and central banks leaders of the G met in Horsham , England, on March to prepare the summit, and pledged to restore global growth as soon as possible. They decided to coordinate their actions and to stimulate demand and employment. They also pledged to fight against all forms of protectionism and to maintain trade and foreign investments. They also committed to maintain the supply of credit by providing more liquidity and recapitalising the banking system, and to implement rapidly the stimulus plans.

As for central bankers, they pledged to maintain low-rates policies as long as necessary. Finally, the leaders decided to help emerging and developing countries, through a strengthening of the IMF. The IMF stated in September that the financial crisis would not end without a major decrease in unemployment as hundreds of millions of people were unemployed worldwide.

The IMF urged governments to expand social safety nets and to generate job creation even as they are under pressure to cut spending. The IMF also encouraged governments to invest in skills training for the unemployed and even governments of countries, similar to that of Greece, with major debt risk to first focus on long-term economic recovery by creating jobs.

The Bank of Israel was the first to raise interest rates after the global recession began. On October 6, , Australia became the first G20 country to raise its main interest rate, with the Reserve Bank of Australia moving rates up from 3. On November 2, , the Bank of England raised interest rates for the first time since March from 0. On April 17, , the then head of the IMF Dominique Strauss-Kahn said that there was a chance that certain countries may not implement the proper policies to avoid feedback mechanisms that could eventually turn the recession into a depression.

Such synchronized recessions were explained to last longer than typical economic downturns and have slower recoveries. Olivier Blanchard , IMF Chief Economist, stated that the percentage of workers laid off for long stints has been rising with each downturn for decades but the figures have surged this time. The last time that the wealth gap reached such skewed extremes was in — From Wikipedia, the free encyclopedia. Early 21st-century global economic decline.

For background on financial market events beginning in , see Financial crisis of — Not to be confused with the Great Depression during the s or the Great Resignation. Causes of the European debt crisis Causes of the United States housing bubble Credit rating agencies and the subprime crisis Government policies and the subprime mortgage crisis.

Summit meetings. Government response and policy proposals. Business failures. Main article: Causes of the Great Recession. Further information: Financial crisis of — Further information: Real estate bubble. Main article: Effects of the Great Recession. Main article: Timeline of the Great Recession. When quarterly change is calculated by comparing quarters with the same quarter of last year, this results only in an aggregated -often delayed- indication, because of being a product of all quarterly changes taking place since the same quarter last year.

Currently there is no seasonal adjusted qoq-data available for Greece and Macedonia, which is why the table display the recession intervals for these two countries only based upon the alternative indicative data format. Main article: National fiscal policy response to the Great Recession. See also: — Keynesian resurgence. Main article: Subprime mortgage crisis. Further information: Corporate debt bubble. Economics portal Money portal. Retrieved December 19, World Economic Situation and Prospects trade paperback 1st ed.

United Nations. ISBN Retrieved July 12, Retrieved February 15, Empirical Economics 58, — Retrieved February 20, Keilis-Borok et al. June 29, Archived from the original on June 17, The New York Times. April 26, Retrieved August 17, New York: Vintage Books, , The Wall Street Journal.

Retrieved September 17, Box 1. April 24, Archived from the original on February 10, Retrieved January 15, December 1, The Guardian. Retrieved April 10,

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Due to this, the initial ratings given to the securitizations in question were AAA ratings, which were likely to be faulty from the beginning. The short-term wholesale market consists of repurchase agreements and commercial paper C. These markets shut down early in the crisis since the participants lacked trust in the collateral quality.

Repos also called repurchase agreements, are utilized by many financial institutions such as banks and money market funds. A typical repo consists of the sale of an asset and a contract to purchase the asset back at a slightly higher price at a later time. At the outset of the repo, the seller receives the cash. Thus, the seller is like the borrower in a collateralized with security such as government bonds and tranches of securitizations loan transaction.

On the other hand, the purchaser of the security who gives the cash at the outset of the repo receives a higher sum at the end of the period of the repo is considered a lender in the context that money received consists of the principal and the interest. With higher lower quality collateral, then it implies a higher lower haircut. Haircut, in this case, refers to the percentage decrease from the initial cash that the lender is willing to give to the borrower.

Haircut protects the lender from receiving less than full value in case the borrower defaults and the lender is forced to sell the collateral in case of default. The insecure commercial paper C. On the other hand, in Asset-backed commercial paper ABCP , the issuer provides the finance to buy assets by issuing a C. In the years preceding the financial crisis, there was a high demand for collateral due to the growth of the OTC derivatives markets and increased dependence on short-term collateralizations by the financial institutions.

However, these demands were quenched by the issuance of the AAA-rated securitization tranches. The Fed statistics showed that the repos increased from USD 1. The SIVs were funded using short-term debt and depended on its flexibility to roll over short-term debt to finance their longer-dated assets. When collateralized mortgages began to lose value, the credit quality of numerous SIVs and increased doubt on the collateral value prevented an increasing number of SIVs from rolling over their ABCP and accompanied a decrease in liquidity in the subprime-related asset markets.

In fact, before mid, counterparty credit was not priced by the market since there was a significant difference between the unsecured overnight index swap OIS rate all periods swap rates. From June , the market participants started to worry about the collateralized securities and the level of exposure of the financial institutions to the subprime market leading to a sharp increase in the OIS-swap spread which remained high during the crisis and increased again when the Lehman Brother failed and did not return to the pre-crisis period.

Additionally, the credit spread on credit assets led to a significant decrease in credit assets. By the summer of , the short-term wholesale funding market began to freeze which included both the ABCP and repo markets. At this point, the investors halted the rolling over of maturing ABCP forcing the banks to recall the SIV assets onto their balance sheets. With the increasing repo haircuts, the financial institutions that relied on the repo financing were unable to roll over their short-term funding, and thus, they were faced with three choices: merger, bailout or bankruptcy.

The amplified uncertainty over the valuation of the asset-backed structured products worsened the financial crisis in the short-term debt markets. This was because the valuation of the asset-backed structured products was difficult. The liability model and cashflow waterfalls were complicated and contained numerous types of collateral and interest rate triggers because, despite that, they have the same securitization structure. There was also the need for the pools of the collateral to be valued.

For instance, for ABS trust, it was necessary to calculate thousands of subprime mortgages with different borrower features and loan terms. The cashflows to some trusts depended on the future values and credit ratings of the collateral, which made modeling the cashflows a complicated undertaking. Moreover, this was worsened by insufficient data on different asset pools presents a challenge even to sophisticated investors. On the transparency issue, some of the seemingly complicated investors lacked the in-house skills to comprehend the complex products they were purchasing.

Moreover, they did have enough knowledge of the underlying risks that might arise from the assumptions they implied in calculating and credit rating models. Thus, many investors relied on credit rating agencies for their risk measurement.

The computation of illiquid assets was blurry due to the lack of readily available reference prices, which made the investors be highly doubtful of the displayed prices when analyzing the credit risk of a counterparty. The potent mixture of uncertainty and lack of transparency catalyzed the subprime crisis in the summer of because the market was skeptical that the past-issued structured products might be mispriced.

There was also some anxiety on the exposure of financial institutions to the subprime market. For instance, Bear Sterns tried to save two hedge funds that were e prone to subprime mortgage losses. One of the primer brokers, Merrill Lynch, called back USD million underlying collateral but had a challenge in selling due to the illiquidity of the markets to some assets at that time.

As a result of these events, the wholesale short-term funding collapsed effectively. The Federal Reserve Fed and other central banks globally devised liquidity injection services. In the time gap between and the end of , the Fed blocked some asset groups that were affected by financial crisis stress. These actions by the Fed included:. Some of the notable government intervention in the U. Systemic risk can be defined as a risk that occurs in one firm or market and can be amplified to the other firms or broader markets.

As a result, the entire markets or economies can be exposed to the risk. Systematic risk played a significant role in worsening the financial crisis. The collateral quality in ABCP and repo markets reduces the default risk by the borrowers. Therefore, the lenders in the market should possess confidence in the type of collateral assets. However, during the financial crisis, the ABCP and the repo fell, lowering the confidence of the lenders in the collateral.

They were concerned that collateral contained subprime mortgages and the reliability of its valuation. Due to a lack of transparency, even the borrower with no prime exposure did not roll over their debt. The valuation of illiquid asset prices is challenging even in normal market conditions. For instance, in the summer of , when BNP Paribas failed to value its illiquid assets, numerous money market managers of the repo markets abandoned it and moved to Treasury bills.

When the ABCP and repos collapsed, many hedge funds failed to roll over the respective debt and were forced to sell assets, and because the funds hold broadly typed of assets, the impact was felt in many markets. For instance, the CDO market was subjected to selling pressure, evidenced by the liquidation of some assets at low prices. Moreover, to close out some current positions, some funds sold high credit-rated assets and bought lower credit-rated assets that were sold at that time.

Consequently, the prices for quality assets fell, and that of lower quality rose affecting the hedge funds traded on pricing patterns. Moreover, banks started to hoard some cash due to the uncertainty of seeming reductions on the decreasing credit lines of SIVs. The refusal to lend became popular among the banks due to the stricter standard.

This negatively affected the hedge funds and other financial institutions, which tightened the availability of mortgages and restriction of business lending. This way, the financial crisis gave birth to an economic crisis! The events that led to the Great Financial Crisis started with a downturn in the US subprime mortgage market in After completing this reading, you should be able to: Explain the arbitrage pricing Read More.

After completing this reading, you should be able to: Explain modern portfolio theory After completing this reading, you should be able to: Describe the various types, After completing this reading, you should be able to: Describe the key features You must be logged in to post a comment. After completing this reading, you should be able to: Describe the historical background and provide an overview of the — financial crisis.

Describe the build-up to the financial crisis and the factors that played an important role. Explain the role of subprime mortgages and collateralized debt obligations CDOs in the crisis. Compare the roles of different types of institutions in the financial crisis, including banks, financial intermediaries, mortgage brokers and lenders, and rating agencies. Describe trends in the short-term wholesale funding markets that contributed to the financial crisis, including their impact on systemic risk.

Describe responses taken by central banks in response to the crisis. Overview and Timeline of the Crisis The start of the financial crisis was marked by runs in several short-term markets previously considered safe. The optimal point for the subprime crisis started in September , which resulted in the following events: Lehman Brothers filed for bankruptcy resulting in a sharp decrease in the interbank borrowing market. That is, the banks with the excess cash refused to lend to those with liquidity problems.

The biggest investment banks in the US, Goldman Sachs, and Morgan Stanley were transformed into bank holding companies, implying that they were regulated by the Fed Federal Reserve. This indicated that they were liable to receive liquidity services from the Federal Reserve. Many European countries had to help their banks. For instance, Fortis a Dutch financial conglomerate was split and sold. Fannie Mae and Freddie Mac were nationalized. Various European government budgets were reduced due to huge capital help to the banks, which led to the European sovereign debt crisis of The debt crisis resulted from countries such as Portugal and Greece taking huge loan packages from the International Monetary Fund IMF and the European Central The effects of the financial crisis were amplified to the broader global economy.

As a result, there was a massive loss of wealth, and the unemployment rate rose all over the world. The Onset of the Great Financial Crisis The low-interest rates in early led to increased demand for housing and related mortgages. Securitization led to: Creation of pools below-investment-grade assets.

Numerous factors can explain the reason for delinquencies after mid Reasons for Delinquencies in Adjustable-Rate Subprime Mortgages Subprime mortgage transactions involved borrowers with weak credit quality. The subprime mortgages are, most of the time, under-collateralized. The involvement of the teaser rates was not a problem if a borrower could refinance the mortgage before the reset date.

Otherwise, if the interest rates rise and the borrower fails to refinance the mortgage, mortgage costs could increase sharply. They were individual investors, pension funds, and hedge funds. That spread the risk throughout the economy.

Hedge funds used these derivatives as collateral to borrow money. That created higher returns in a bull market but magnified the impact of any downturn. Throughout the summer, banks became unwilling to lend to each other. Bankers didn't know how much bad debt they had on their books.

No one wanted to admit it. If they did, then their credit rating would be lowered. Then, their stock price would fall, and they would be unable to raise more funds to stay in business. The stock market see-sawed throughout the summer, as market-watchers tried to figure out how bad things were. Instead, banks stopped lending to almost everybody. The downward spiral was underway. As banks cut back on mortgages, housing prices fell further.

That made more borrowers go into default, which increased the bad loans on banks' books. That made the banks lend even less. Over the next eight months, the Fed lowered interest rates from 5. But nothing could make the banks trust each other again. Two things could have prevented the crisis. The first would have been regulation of mortgage brokers, who made the bad loans, and hedge funds, which used too much leverage.

The second would have been recognized early on that it was a credibility problem. The only solution was for the government to buy bad loans. But the financial crisis was also caused by financial innovation that outstripped human intellect.

The potential impact of new products, like MBS and derivatives, were not understood even by the quant jocks who created them. It couldn't have prevented the creation of new financial products. To some extent, fear and greed will always create bubbles. Innovation will always have an impact that isn't apparent until well after the fact. Census Bureau. The Federal Reserve Board. Department of the Treasury. Board of Governors of the Federal Reserve System.

Government Publishing Office. Securities and Exchange Commission. Wharton School University of Pennsylvania. Federal Reserve Bank of San Francisco. Table of Contents Expand. Table of Contents. First Signs of the Crisis. Real Cause of the Crisis. The Fed Intervenes. An Ounce of Prevention. US Economy Fiscal Policy. By Kimberly Amadeo. Learn about our editorial policies. Reviewed by Charles Potters.

Charles is a nationally recognized capital markets specialist and educator with over 30 years of experience developing in-depth training programs for burgeoning financial professionals. Charles has taught at a number of institutions including Goldman Sachs, Morgan Stanley, Societe Generale, and many more.

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This is analogous to allowing many persons to buy insurance on the same house. Speculators that bought CDS insurance were betting that significant defaults would occur, while the sellers such as AIG bet they would not. A theoretically infinite amount could be wagered on the same housing-related securities, provided buyers and sellers of the CDS could be found. Derivatives such as CDS were unregulated or barely regulated.

Several sources have noted the failure of the US government to supervise or even require transparency of the financial instruments known as derivatives. In Brooksley E. Born , head of the Commodity Futures Trading Commission , put forth a policy paper asking for feedback from regulators, lobbyists, legislators on the question of whether derivatives should be reported, sold through a central facility, or whether capital requirements should be required of their buyers.

Greenspan, Rubin, and Levitt pressured her to withdraw the paper and Greenspan persuaded Congress to pass a resolution preventing CFTC from regulating derivatives for another six months — when Born's term of office would expire. NPR reported that Magnetar encouraged investors to purchase CDO's while simultaneously betting against them, without disclosing the latter bet. Companies were able to sell protection to investors against the default of mortgage-backed securities, helping to launch and expand the market for new, complex instruments such as CDO's.

This further fueled the housing bubble. They also amplified the losses from the collapse of the housing bubble by allowing multiple bets on the same securities and helped spread these bets throughout the financial system. Companies selling protection, such as AIG , were not required to set aside sufficient capital to cover their obligations when significant defaults occurred.

Because many CDS were not traded on exchanges, the obligations of key financial institutions became hard to measure, creating uncertainty in the financial system. Securities and Exchange Commissioner [] , their performance "horrendous" The Economist magazine []. There are indications that some involved in rating subprime-related securities knew at the time that the rating process was faulty. The position of the three agencies "between the issuers and the investors of securities" [] "transformed" them into "key" players in the housing bubble and financial crisis according to the Financial Crisis Inquiry Report.

Most investors in the fixed income market had no experience with the mortgage business — let alone dealing with the complexity of pools of mortgages and tranche priority of MBS and CDO securities [] — and were simply looking for an independent party who could rate securities. In addition, a large section of the debt securities market — many money markets and pension funds — were restricted in their bylaws to holding only the safest securities — i.

Hence non-prime securities could not be sold without ratings by usually two of the three agencies. From to , one of the largest agencies — Moody's — rated nearly 45, mortgage-related securities [] — more than half of those it rated — as triple-A. As these mortgages began to default, the three agencies were compelled to go back and redo their ratings. Critics such as the FCIC argue the mistaken credit ratings stemmed from "flawed computer models, the pressure from financial firms that paid for the ratings, the relentless drive for market share, the lack of resources to do the job despite record profits, and the absence of meaningful public oversight".

Structured investment was very profitable to the agencies and by accounted for just under half of Moody's total ratings revenue and all of the revenue growth. This incentivized agency rating analysts to seek employment at those Wall Street banks who were issuing mortgage securities, and who were particularly interested in the analysts' knowledge of what criteria their former employers used to rate securities. As of , virtually all of the investigations of rating agencies, criminal as well as civil, are in their early stages.

Government over-regulation, failed regulation and deregulation have all been claimed as causes of the crisis. Increasing home ownership has been the goal of several presidents including Roosevelt, Reagan, Clinton and George W.

Those of us who have looked to the self-interest of lending institutions to protect shareholders' equity, myself included, are in a state of shocked disbelief. Alan Greenspan []. Several steps were taken to deregulate banking institutions in the years leading up to the crisis.

Further, major investment banks which collapsed during the crisis were not subject to the regulations applied to depository banks. This bi-partisan legislation was, according to the Urban Institute, intended to "increase the volume of loan products that reduced the up-front costs to borrowers in order to make homeownership more affordable.

Subsequent widespread abuses of predatory lending occurred with the use of adjustable-rate mortgages. It separated commercial banks and investment banks , in part to avoid potential conflicts of interest between the lending activities of the former and rating activities of the latter. Economist Joseph Stiglitz criticized the repeal of Glass—Steagall because, in his opinion, it enabled the risk-taking culture of investment banking to dominate the more conservative commercial banking culture, leading to increased levels of risk-taking and leverage during the boom period.

The Commodity Futures Modernization Act of was bi-partisan legislation that formally exempted derivatives from regulation, supervision, trading on established exchanges, and capital reserve requirements for major participants.

It "provided a legal safe harbor for treatment already in effect. Particularly relevant to the crisis are credit default swaps CDS , a derivative in which Party A pays Party B what is essentially an insurance premium, in exchange for payment should Party C default on its obligations. Warren Buffett famously referred to derivatives as "financial weapons of mass destruction" in early Former Fed Chair Alan Greenspan , who many economists blamed for the financial crisis, testified in October that he had trusted free markets to self-correct and had not anticipated the risk of reduced lending standards.

Some analysts believe the subprime mortgage crisis was due, in part, to a decision of the SEC that affected 5 large investment banks. The critics believe that changes in the capital reserve calculation rules enabled investment banks to substantially increase the level of debt they were taking on, fueling the growth in mortgage-backed securities supporting subprime mortgages.

These banks dramatically increased their risk taking from to By the end of , the largest five U. Several administrations, both Democratic and Republican, advocated private home ownership in the years leading up to the crisis. However, HUD was given the power to set future requirements. This page document represented the viewpoints of HUD, Fannie Mae, Freddie Mac, leaders of the housing industry, various banks, numerous activist organizations such as ACORN and La Raza, and representatives from several state and local governments.

Widespread as this belief has become in conservative circles, virtually all serious attempts to evaluate the evidence have concluded that there is little merit in this view. Joseph Stiglitz []. The Financial Crisis Inquiry Commission majority report , Federal Reserve economists, and several academic researchers have stated that government affordable housing policies were not the major cause of the financial crisis.

The Community Reinvestment Act CRA was originally enacted under President Jimmy Carter in in an effort to encourage banks to halt the practice of lending discrimination. Conservatives and libertarians have debated the possible effects of the CRA, with detractors claiming that the Act encouraged lending to uncreditworthy borrowers, [] [] [] [] and defenders claiming a thirty-year history of lending without increased risk.

Many subprime lenders were not subject to the CRA. Loans made by CRA-regulated lenders in the neighborhoods in which they were required to lend were half as likely to default as similar loans made in the same neighborhoods by independent mortgage originators not subject to the law. Critics claim that the use of the high-interest-rate proxy distorts results because government programs generally promote low-interest rate loans—even when the loans are to borrowers who are clearly subprime.

This comparison clearly indicates that adherence to the CRA led to riskier lending by banks. As part of the National Homeownership Strategy, HUD advocated greater involvement of state and local organizations in the promotion of affordable housing. The loans were called "silent" because the primary lender was not supposed to know about them. Instead of going to the family, the monthly voucher is paid to [the NRC affiliates].

In this way the voucher is "invisible" to the traditional lender and the family emphasis added []. Fannie Mae and Freddie Mac are government sponsored enterprises GSE that purchase mortgages, buy and sell mortgage-backed securities MBS , and guarantee nearly half of the mortgages in the U. A variety of political and competitive pressures resulted in the GSEs ramping up their purchase and guarantee of risky mortgages in and , just as the housing market was peaking.

As early as February , in testimony before the U. He implored Congress to take actions to avert a crisis. Nine of the ten members of the Financial Crisis Inquiry Commission reported in that Fannie and Freddie "contributed to the crisis, but were not a primary cause", [] or that since "credit spreads declined not just for housing, but also for other asset classes like commercial real estate The GSEs participated in the expansion of subprime and other risky mortgages, but they followed rather than led Wall Street and other lenders into subprime lending.

Whether GSEs played a small role in the crisis because they were legally barred from engaging in subprime lending is disputed. Insofar as Fannie and Freddie did purchase substandard loans, some analysts question whether government mandates for affordable housing were the motivation. In December the Securities and Exchange Commission charged the former Fannie Mae and Freddie Mac executives, accusing them of misleading investors about risks of subprime-mortgage loans and about the amount of subprime mortgage loans they held in portfolio.

With marketshare came bonuses and with bonuses came risk-taking, understood or not. Daniel H. Mudd, the former CEO of Fannie Mae, stated: "We were afraid that lenders would be selling products we weren't buying and Congress would feel like we weren't fulfilling our mission. So that's what we did. The effect of these defaults was exacerbated by the fact that few if any investors — including housing market analysts — understood at the time that Fannie Mae and Freddie Mac had been acquiring large numbers of subprime and other high risk loans in order to meet HUD's affordable housing goals.

Government entities held or guaranteed One counter-argument to Wallison and Pinto's analysis is that the credit bubble was global and also affected the U. The three Republican authors of the dissenting report to the FCIC majority opinion wrote in January "Credit spreads declined not just for housing, but also for other asset classes like commercial real estate.

This tells us to look to the credit bubble as an essential cause of the U. It also tells us that problems with U. Countering the analysis of Krugman and members of the FCIC, Peter Wallison argues that the crisis was caused by the bursting of a real estate bubble that was supported largely by low or no-down-payment loans , which was uniquely the case for U.

He states: "It is not true that every bubble — even a large bubble — has the potential to cause a financial crisis when it deflates. Other analysis calls into question the validity of comparing the residential loan crisis to the commercial loan crisis. After researching the default of commercial loans during the financial crisis, Xudong An and Anthony B.

Sanders reported in December : "We find limited evidence that substantial deterioration in CMBS [commercial mortgage-backed securities] loan underwriting occurred prior to the crisis. Business journalist Kimberly Amadeo wrote "The first signs of decline in residential real estate occurred in Three years later, commercial real estate started feeling the effects. Gierach, a real estate attorney and CPA, wrote:.

In other words, the borrowers did not cause the loans to go bad, it was the economy. A second counter-argument to Wallison's dissent is that the definition of "non-traditional mortgages" used in Pinto's analysis overstated the number of risky mortgages in the system by including Alt-A, which was not necessarily high-risk.

Central banks manage monetary policy and may target the rate of inflation. They have some authority over commercial banks and possibly other financial institutions. They are less concerned with avoiding asset price bubbles , such as the housing bubble and dot-com bubble.

Central banks have generally chosen to react after such bubbles burst so as to minimize collateral damage to the economy, rather than trying to prevent or stop the bubble itself. This is because identifying an asset bubble and determining the proper monetary policy to deflate it are matters of debate among economists. Some market observers have been concerned that Federal Reserve actions could give rise to moral hazard. A contributing factor to the rise in house prices was the Federal Reserve's lowering of interest rates early in the decade.

From to , the Federal Reserve lowered the federal funds rate target from 6. The Fed believed that interest rates could be lowered safely primarily because the rate of inflation was low; it disregarded other important factors.

According to Richard W. Fisher, President and CEO of the Federal Reserve Bank of Dallas , the Fed's interest rate policy during the early s decade was misguided, because measured inflation in those years was below true inflation, which led to a monetary policy that contributed to the housing bubble. Ben Bernanke and Alan Greenspan — both former chairmen of the Federal Reserve — disagree, arguing decisions on purchasing a home depends on long-term interest rates on mortgages not the short-term rates controlled by the Fed.

Construction of new homes did not peak until January Agreeing with Fisher that the low interest rate policy of the Greenspan Fed both allowed and motivated investors to seek out risk investments offering higher returns, is finance economist Raghuram Rajan who argues that the underlying causes of the American economy's tendency to go "from bubble to bubble" fueled by unsustainable monetary stimulation, are the "weak safety nets" for the unemployed, which made "the US political system Economist Thomas Sowell wrote that the Fed's decision to steadily raise interest rates was a key factor that ended the housing bubble.

By driving mortgage rates higher, the Fed "made monthly mortgage payments more expensive and therefore reduced the demand for housing. Former Federal Deposit Insurance Corporation Chair William Isaac placed much of the blame for the subprime mortgage crisis on the Securities and Exchange Commission and its fair-value accounting rules, especially the requirement for banks to mark their assets to market, particularly mortgage-backed securities.

The debate arises because this accounting rule requires companies to adjust the value of marketable securities such as the mortgage-backed securities MBS at the center of the crisis to their market value. The intent of the standard is to help investors understand the value of these assets at a point in time, rather than just their historical purchase price.

Because the market for these assets is distressed, it is difficult to sell many MBS at other than prices which may or may not be reflective of market stresses, which may be below the value that the mortgage cash flow related to the MBS would merit. As initially interpreted by companies and their auditors, the typically lower sale value was used as the market value rather than the cash flow value. Many large financial institutions recognized significant losses during and as a result of marking-down MBS asset prices to market value.

In , Ben Bernanke addressed the implications of the United States's high and rising current account deficit, resulting from U. The balance of payments identity requires that a country such as the U. Bernanke referred to this as a " saving glut " [] that may have pushed capital into the United States, a view differing from that of some other economists, who view such capital as having been pulled into the U.

In other words, a nation cannot consume more than its income unless it sells assets to foreigners, or foreigners are willing to lend to it. Alternatively, if a nation wishes to increase domestic investment in plant and equipment, it will also increase its level of imports to maintain balance if it has a floating exchange rate. Regardless of the push or pull view, a "flood" of funds capital or liquidity reached the U.

Foreign governments supplied funds by purchasing U. Treasury bonds and thus avoided much of the direct impact of the crisis. American 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. American housing and financial assets dramatically declined in value after the housing bubble burst.

Economist Joseph Stiglitz wrote in October that the recession and high unemployment of the — period was years in the making and driven by: unsustainable consumption; high manufacturing productivity outpacing demand thereby increasing unemployment; income inequality that shifted income from those who tended to spend it i. These factors all led to a "massive" shortfall in aggregate demand, which was "papered over" by demand related to the housing bubble until it burst. Financial market stresses became apparent during that resulted in sizable losses across the financial system, the bankruptcy of over mortgage lenders and the emergency sale of investment bank Bear Stearns in March to depository bank JP Morgan Chase.

Some writers began calling the events in the financial markets during this period the "Subprime Mortgage Crisis" or the "Mortgage crisis". The increase was driven by increased expected losses in its US mortgage portfolio; this was the first major subprime related loss to be reported. They had relied on continuing access to this global pool of investor capital to continue their operations; when investor capital dried-up, they were forced into bankruptcy.

Other parts of the shadow banking system also encountered difficulty. Legal entities known as structured investment vehicles SIV and hedge funds had borrowed from investors and bought MBS's. When mortgage defaults rose along with the fall in housing prices, the value of the MBS declined. Investors demanded that these entities put up additional collateral or be forced to pay back the investors immediately, a form of margin call.

This dynamic of margin call and price reductions contributed to the collapse of two Bear Stearns hedge funds in July , an event which economist Mark Zandi referred to as "arguably the proximate catalyst" of the crisis in financial markets. Investment banks such as Bear Stearns had legal obligations to provide financial support to these entities, which created a cash drain. Bear Stearns reported the first quarterly loss in its history during November and obtained additional financing from a Chinese sovereign wealth fund.

Investment banks Merrill Lynch and Morgan Stanley had also obtained additional capital from sovereign wealth funds in Asia and the Middle East during late The major investment banks had also increased their own borrowing and investing as the bubble expanded, taking on additional risk in the search for profit. Unable to withstand the combination of high leverage, reduced access to capital, loss in the value of its MBS securities portfolio, and claims from its hedge funds, Bear Stearns collapsed during March Financial market conditions continued to worsen during These losses wiped out much of the capital of the world banking system.

Banks headquartered in nations that have signed the Basel Accords must have so many cents of capital for every dollar of credit extended to consumers and businesses. Thus the massive reduction in bank capital just described has reduced the credit available to businesses and households. The crisis hit a critical point in September with the failure, buyout or bailout of the largest entities in the U. Investment banks Goldman Sachs and Morgan Stanley obtained depository bank holding charters, which gave them access to emergency lines of credit from the Federal Reserve.

Insurance giant AIG , which had sold insurance-like protection for mortgage-backed securities, did not have the capital to honor its commitments; U. Further, there was the equivalent of a bank run on other parts of the shadow system, which severely disrupted the ability of non-financial institutions to obtain the funds to run their daily operations. The TED spread see graph above , a measure of the risk of interbank lending, quadrupled shortly after the Lehman failure.

This credit freeze brought the global financial system to the brink of collapse. Bernanke reportedly told them: "If we don't do this, we may not have an economy on Monday. This was the largest liquidity injection into the credit market, and the largest monetary policy action, in world history. The International Monetary Fund estimated that large U. The IMF estimated that U. Between June and November , Americans lost more than a quarter of their net worth.

By early November , a broad U. Members of US minority groups received a disproportionate number of subprime mortgages, and so have experienced a disproportionate level of the resulting foreclosures. Borrowers with complex mortgages experienced substantially higher default rates than borrowers with traditional mortgages with similar characteristics. New vehicle sales, which peaked at 17 million in , recovered to only 12 million by The crisis in Europe generally progressed from banking system crises to sovereign debt crises, as many countries elected to bail out their banking systems using taxpayer money.

Greece was different in that it concealed large public debts in addition to issues within its banking system. Several countries received bailout packages from the "troika" European Commission, European Central Bank, International Monetary Fund , which also implemented a series of emergency measures.

Many European countries embarked on austerity programs, reducing their budget deficits relative to GDP from to However, with the exception of Germany, each of these countries had public-debt-to-GDP ratios that increased i. Eurostat reported that the debt to GDP ratio for the 17 Euro area countries together was Unemployment is another variable that might be considered in evaluating austerity measures.

France and Italy had no significant changes, while in Germany and Iceland the unemployment rate declined. Unemployment varied significantly by country. Economist Martin Wolf analyzed the relationship between cumulative GDP growth from to and total reduction in budget deficits due to austerity policies see chart in several European countries during April He concluded that: "In all, there is no evidence here that large fiscal contractions [budget deficit reductions] bring benefits to confidence and growth that offset the direct effects of the contractions.

They bring exactly what one would expect: small contractions bring recessions and big contractions bring depressions. Economist Paul Krugman analyzed the relationship between GDP and reduction in budget deficits for several European countries in April and concluded that austerity was slowing growth, similar to Martin Wolf.

He also wrote: "this also implies that 1 euro of austerity yields only about 0. No wonder, then, that the whole austerity enterprise is spiraling into disaster. The crisis had a significant and long-lasting impact on U.

During the Great Recession , 8. From February to September , approximately 4. In Spring there were about a million homes in foreclosure in the United States, several million more in the pipeline, and , previously foreclosed homes in the hands of banks. According to Mark Zandi of Moody's Analytics , home prices were falling and could be expected to fall further during However, the rate of new borrowers falling behind in mortgage payments had begun to decrease.

Research indicates recovery from financial crises can be protracted, with lengthy periods of high unemployment and substandard economic growth. And in the decade following severe financial crises, you tend to grow by 1 to 1.

The unemployment figures in advanced economies after falls are also very dark. Unemployment remains anchored about five percentage points above what it was in the decade before. During the crisis and ensuing recession, U. In a healthy economy, private sector savings placed into the banking system is borrowed and invested by companies.

This investment is one of the major components of GDP. Part of this investment reduction related to the housing market, a major component of investment in the GDP computation. This surplus explains how even significant government deficit spending would not increase interest rates and how Federal Reserve action to increase the money supply does not result in inflation, because the economy is awash with savings with no place to go.

Economist Richard Koo described similar effects for several of the developed world economies in December Today private sectors in the U. This means these countries are all in serious balance sheet recessions. The private sectors in Japan and Germany are not borrowing, either. With borrowers disappearing and banks reluctant to lend, it is no wonder that, after nearly three years of record low interest rates and massive liquidity injections, industrial economies are still doing so poorly.

Flow of funds data for the U. The shift for the private sector as a whole represents over 9 percent of U. GDP at a time of zero interest rates. Moreover, this increase in private sector savings exceeds the increase in government borrowings 5. Economist Wynne Godley explained in — how U. The combination of a high and growing foreign sector surplus and high government sector deficit meant that the private sector was moving towards a net borrowing position from surplus to deficit as a housing bubble developed, which he warned was an unsustainable combination.

Economist Martin Wolf explained in July that government fiscal balance is one of three major financial sectoral balances in the U. The sum of the surpluses or deficits across these three sectors must be zero by definition. In the U. Further, there is a private sector financial surplus due to household savings exceeding business investment.

By definition, there must therefore exist a government budget deficit so all three net to zero. The government sector includes federal, state and local. Wolf argued that the sudden shift in the private sector from deficit to surplus forced the government balance into deficit, writing: "The financial balance of the private sector shifted towards surplus by the almost unbelievable cumulative total of No fiscal policy changes explain the collapse into massive fiscal deficit between and , because there was none of any importance.

The collapse is explained by the massive shift of the private sector from financial deficit into surplus or, in other words, from boom to bust. Various actions have been taken since the crisis became apparent in August In September , major instability in world financial markets increased awareness and attention to the crisis. Various agencies and regulators, as well as political officials, began to take additional, more comprehensive steps to handle the crisis. To date, various government agencies have committed or spent trillions of dollars in loans, asset purchases, guarantees, and direct spending.

For a summary of U. The central bank of the US, the Federal Reserve , in partnership with central banks around the world, took several steps to address the crisis. According to Ben Bernanke , expansion of the Fed balance sheet means the Fed is electronically creating money, necessary "because our economy is very weak and inflation is very low. When the economy begins to recover, that will be the time that we need to unwind those programs, raise interest rates, reduce the money supply, and make sure that we have a recovery that does not involve inflation.

It plans to hold short-term interest rates near zero even longer, at least until the unemployment rate falls below 6. On February 13, , President George W. However, this rebate coincided with an unexpected jump in gasoline and food prices. This coincidence led some to wonder whether the stimulus package would have the intended effect, or whether consumers would simply spend their rebates to cover higher food and fuel prices.

On February 17, , U. This program is referred to as the Homeowner Affordability and Stability Plan. Losses on mortgage-backed securities and other assets purchased with borrowed money have dramatically reduced the capital base of financial institutions, rendering many either insolvent or less capable of lending.

Governments have provided funds to banks. Some banks have taken significant steps to acquire additional capital from private sources. Another method of recapitalizing banks is for government and private investors to provide cash in exchange for mortgage-related assets i. Treasury Secretary Timothy Geithner announced a plan during March to purchase "legacy" or "toxic" assets from banks. The Public-Private Partnership Investment Program involves government loans and guarantees to encourage private investors to provide funds to purchase toxic assets from banks.

Some elements of TARP such as foreclosure prevention aid will not be paid back. Several major financial institutions either failed, were bailed out by governments, or merged voluntarily or otherwise during the crisis. While the specific circumstances varied, in general the decline in the value of mortgage-backed securities held by these companies resulted in either their insolvency , the equivalent of bank runs as investors pulled funds from them, or inability to secure new funding in the credit markets.

These firms had typically borrowed and invested large sums of money relative to their cash or equity capital, meaning they were highly leveraged and vulnerable to unanticipated credit market disruptions. The five largest U. Major depository banks around the world had also used financial innovations such as structured investment vehicles to circumvent capital ratio regulations. Dozens of U.

As a result of the financial crisis in , twenty-five U. According to some, the bailouts could be traced directly to Alan Greenspan's efforts to reflate the stock market and the economy after the tech stock bust, and specifically to a February 23, , speech Mr. Greenspan made to the Mortgage Bankers Association where he suggested that the time had come to push average American borrowers into more exotic loans with variable rates, or deferred interest.

Greenspan sought to enlist banks to expand lending and debt to stimulate asset prices and that the Federal Reserve and US Treasury Department would back any losses that might result. Both lenders and borrowers may benefit from avoiding foreclosure, which is a costly and lengthy process. Some lenders have offered troubled borrowers more favorable mortgage terms e. Borrowers have also been encouraged to contact their lenders to discuss alternatives. The Economist described the issue this way in February "No part of the financial crisis has received so much attention, with so little to show for it, as the tidal wave of home foreclosures sweeping over America.

Government programmes have been ineffectual, and private efforts not much better. A variety of voluntary private and government-administered or supported programs were implemented during — to assist homeowners with case-by-case mortgage assistance, to mitigate the foreclosure crisis engulfing the U. One example is the Hope Now Alliance , an ongoing collaborative effort between the US Government and private industry to help certain subprime borrowers.

A spokesperson for the Alliance acknowledged that much more must be done. During late , major banks and both Fannie Mae and Freddie Mac established moratoriums delays on foreclosures, to give homeowners time to work towards refinancing. FDIC reported that more than half of mortgages modified during the first half of were delinquent again, in many cases because payments were not reduced or mortgage debt was not forgiven.

This is further evidence that case-by-case loan modification is not effective as a policy tool. Lowering the mortgage balance would help lower monthly payments and also address an estimated 20 million homeowners that may have a financial incentive to enter voluntary foreclosure because they are "underwater" i. A study by the Federal Reserve Bank of Boston indicated that banks were reluctant to modify loans. In addition, investors who hold MBS and have a say in mortgage modifications have not been a significant impediment; the study found no difference in the rate of assistance whether the loans were controlled by the bank or by investors.

Commenting on the study, economists Dean Baker and Paul Willen both advocated providing funds directly to homeowners instead of banks. Such strategic defaults were heavily concentrated in markets with the highest price declines. An estimated , strategic defaults occurred nationwide during , more than double the total in On February 18, , U. The plan also involves forgiving a portion of the borrower's mortgage balance.

Companies that service mortgages will get incentives to modify loans and to help the homeowner stay current. Untold thousands of people have complained in recent years that they were subjected to a nightmare experience of lost paperwork, misapplied fees and Kafkaesque phone calls with clueless customer service representatives as they strived to avoid foreclosures they say were preventable. These claims are backed up by a swelling number of academic studies and insider accounts of misconduct and abuse.

Now it's becoming clear just how chaotic the whole system became. Depositions from employees working for the banks or their law firms depict a foreclosure process in which it was standard practice for employees with virtually no training to masquerade as vice presidents, sometimes signing documents on behalf of as many as 15 different banks.

Together, the banks and their law firms created a quick-and-dirty foreclosure machine that was designed to rush through foreclosures as fast as possible. President Barack Obama and key advisers introduced a series of regulatory proposals in June 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.

His testimony included five elements he stated as critical to effective reform:. The Dodd-Frank Act addressed these elements, but stopped short of breaking up the largest banks, which grew larger due to mergers of investment banks at the core of the crisis with depository banks e. Assets of five largest banks as a share of total commercial banking assets rose then stabilized in the wake of the crisis. These were separated prior to the repeal of the Glass-Steagall Act. Significant law enforcement action and litigation resulted from the crisis.

Several hundred civil lawsuits were filed in federal courts beginning in related to the subprime crisis. The number of filings in state courts was not quantified but was also believed to be significant. The deal with the U. Justice Department topped a deal the regulator made the previous year with JPMorgan Chase over similar issues. The Economist estimated that from through October , U. Attorney's offices, and state and local partners.

One of its eight working groups, the Residential Mortgage Backed Securities RMBS Working Group, was created in and is involved in investigating and negotiating many of the fines and penalties described above. Several books written about the crisis were made into movies. The former tells the story from the perspective of several investors who bet against the housing market, while the latter follows key government and banking officials focusing on the critical events of September , when many large financial institutions faced or experienced collapse.

Estimates of impact have continued to climb. Francis Fukuyama has argued that the crisis represents the end of Reaganism in the financial sector, which was characterized by lighter regulation, pared-back government, and lower taxes. Significant financial sector regulatory changes are expected as a result of the crisis. Fareed Zakaria believes that the crisis may force Americans and their government to live within their means.

Further, some of the best minds may be redeployed from financial engineering to more valuable business activities, or to science and technology. Roger Altman wrote that "the crash of has inflicted profound damage on [the U. Over the medium term, the United States will have to operate from a smaller global platform — while others, especially China, will have a chance to rise faster. America must regain its competitiveness through innovative products, training of production workers, and business leadership.

He advocates specific national goals related to energy security or independence, specific technologies, expansion of the manufacturing job base, and net exporter status. Now we must lead an aggressive American renewal to win in the future. Economist Paul Krugman wrote in "The prosperity of a few years ago, such as it was—profits were terrific, wages not so much — depended on a huge bubble in housing, which replaced an earlier huge bubble in stocks. And since the housing bubble isn't coming back, the spending that sustained the economy in the pre-crisis years isn't coming back either.

These commitments can be characterized as investments, loans, and loan guarantees, rather than direct expenditures. In many cases, the government purchased financial assets such as commercial paper, mortgage-backed securities, or other types of asset-backed paper, to enhance liquidity in frozen markets. The Economist wrote in May "Having spent a fortune bailing out their banks, Western governments will have to pay a price in terms of higher taxes to meet the interest on that debt.

In the case of countries like Britain and America that have trade as well as budget deficits, those higher taxes will be needed to meet the claims of foreign creditors. Given the political implications of such austerity, the temptation will be to default by stealth, by letting their currencies depreciate. Investors are increasingly alive to this danger Senator Chris Dodd claimed that Greenspan created the " perfect storm ". The current credit crisis will come to an end when the overhang of inventories of newly built homes is largely liquidated, and home price deflation comes to an end.

That will stabilize the now-uncertain value of the home equity that acts as a buffer for all home mortgages, but most importantly for those held as collateral for residential mortgage-backed securities. Very large losses will, no doubt, be taken as a consequence of the crisis. But after a period of protracted adjustment, the U. Following the recession of the — era, there became a bigger focus from millennials on how mortgages affect their personal finances. Most who were of working age were unable to find employment that would allow them to save enough for a house.

The lack of good employment opportunities has created questions among this generation about how much of their lives that they are willing to invest into a home and if that money is not better spent elsewhere. Mortgage Magnitude [] looks at how many years of life a mortgage will actually cost a consumer given the area's median income and median home value, showing homes in metropolitan areas ranging from ratios of to Donna Fancher researched to find if the " American Dream " of owning a home is still a realistic goal, or if it is continually shrinking for the youth of the US, writing:.

In many markets, prospective buyers are continuing to rent due to concerns over affordability. However, demand also increases rent disproportionately. While housing prices fell dramatically during the recession, prices have been steadily coming back to pre-recession prices; with a rising interest rate , home ownership could continue to be challenging for millennials.

Jason Furman wrote:. W hile the unemployment rate for those over 34 peaked at about 8 percent, the unemployment rate among those between the ages of 18 and 34 peaked at 14 percent in and remains elevated, despite substantial improvement; delinquency rates on student loans have risen several percentage points since the Great Recession and even into the recovery; and the homeownership rate among young adults has dropped from a peak of 43 percent in to 37 percent in concurrent with a large increase in the share living with their parents.

The recession officially ended in the second quarter of , [] but the nation's economy continued to be described as in an " economic malaise " during the second quarter of Household incomes , as of August , had fallen more since the end of the recession, than during the month recession, falling an additional 4. However, the Great Recession was different in kind from all the recessions since the Great Depression, as it also involved a banking crisis and the de-leveraging debt reduction of highly indebted households.

Then-Fed Chair Ben Bernanke explained during November several of the economic headwinds that slowed the recovery:. For example, U. This reduced real GDP growth by approximately 0. Several key economic variables e. The gains were more evenly distributed after the tax increases in on higher-income earners. President Obama declared the bailout measures started under the Bush Administration and continued during his Administration as completed and mostly profitable as of December From Wikipedia, the free encyclopedia.

December —June banking emergency in the US. Causes of the European debt crisis Causes of the United States housing bubble Credit rating agencies and the subprime crisis Government policies and the subprime mortgage crisis. Summit meetings. Government response and policy proposals. Business failures. Main articles: Subprime crisis background information , Subprime crisis impact timeline , United States housing bubble , and United States housing market correction.

Further information: Causes of the — global financial crisis and Causes of the United States housing bubble. Main articles: United States housing bubble and United States housing market correction. Main article: Speculation. Further information: Securitization and Mortgage-backed security. Main article: Credit rating agencies and the subprime crisis. Main article: Government policies and the subprime mortgage crisis.

Main article: Fair value accounting and the subprime mortgage crisis. Further information: List of writedowns due to subprime crisis. Further information: Indirect economic effects of the subprime mortgage crisis. Main article: Financial crisis of — Further information: European sovereign-debt crisis and Austerity.

Main article: Sectoral financial balances. Further information: Subprime mortgage crisis solutions debate. Main article: Federal Reserve responses to the subprime crisis. Main article: Emergency Economic Stabilization Act of See also: United Kingdom bank rescue package. Further information: List of bankrupt or acquired banks during the financial crisis of — , Federal takeover of Fannie Mae and Freddie Mac , National City acquisition by PNC , Government intervention during the subprime mortgage crisis , and Bailout.

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Social Science Electronic Publishing. Retrieved October 18, September 19, Retrieved September 8, December 4, Archived from the original on July 17, But Then Again. Archived from the original on April 15, Associated Press.

March 13, Bernanke May 17, The Subprime Mortgage Market Speech. Chicago, Illinois. July 17, Archived from the original PDF on June 30, San Francisco Chronicle. Retrieved April 8, Mortgage Bankers Association. June 12, Archived from the original on June 18, Bernanke October 17, New York City , New York. Bernanke January 10, Washington, D.

Retrieved June 5, Mortgage Delinquencies and Foreclosures Speech. Federal Reserve System, Release Z. Table L. January 29, Archived from the original on April 26, Retrieved June 6, January 15, Archived from the original on May 14, November 19, Archived from the original on July 28, NY Post.

Archived from the original on August 30, August 25, Retrieved October 5, — via LA Times. March 28, New York Review of Books. The Return of Depression Economics and the Crisis of Norton Company Limited. Archived from the original on June 3, January 27, March 25, All the Devils Are Here. Portfolio, Penguin. After the REMIC battle, [whatever that was] Wall Street realized it was never going to dislodge Fannie and Freddie from their dominant position as the securitizers of traditional mortgages.

Wall Street would have to find some other mortgage product to securitize, products that Fannie and Feddie couldn't — or wouldn't — touch. Review of Financial Studies. January 31, Claremont Institute. Archived from the original on December 24, Retrieved September 30, As a result, the credit rating downgrades for the subprime mortgage securitized products increased massively.

The banks securitized their assets off their balance sheets to structured investment vehicles SIVs , also termed as conduits. SIVs are the companies utilized by the banks to purchase assets and funds by short-term commercial paper and medium-term notes and capital.

Securitization is a process where the cash flows from a portfolio are repackaged into claims on tranches a pooled group of securities such as debt instruments classified in terms of risk or other features to attract different investors , and the returns from the tranches are used to buy the collateral assets. To attract different investors, tranches are modeled to have the desired rating depending on the credit risk associated with a tranch.

The rating on tranches is structured in terms of how safe it is. Theoretically, the OTD model with appropriate securitization would diffuse the risk throughout the financial system. However, this theory failed miserably. According to Basel II, from , banks used securitization to keep their credit exposure to AAA-rated tranches to create high extra returns without raising their regulatory capital minimums. As a result of the AAA rating, investors did not mind conducting due diligence on the pool and thought that they could earn risk-free returns by buying CDOs instead of lower-yielding similar assets such as bonds.

They were utterly wrong because most of the ratings were based on historical data, which, at that time, did not reflect the variation of asset features that were taking place. The CDO trust partners also called equity holders would pay the credit rating agencies to rate various liabilities associated with the CDO to acquire high proportions of AAA-rated bonds.

Moreover, their rating was based on historical data, which did not reflect the variation of asset features that were taking place such as NINJA loans, liar loans, and subprime mortgages. Moreover, the rating agencies used the data from the organizers and the issuers of the mortgages who performed due diligence analysis. However, although the rating companies knew about the decline of the leading standards and rising fraud, the rating agencies did not do further due diligence or pay close attention to the available data.

The subprime mortgages were the new products in the market. Therefore, there was no enough data for the analyst to perform a prior risk analysis. Due to this, the initial ratings given to the securitizations in question were AAA ratings, which were likely to be faulty from the beginning.

The short-term wholesale market consists of repurchase agreements and commercial paper C. These markets shut down early in the crisis since the participants lacked trust in the collateral quality. Repos also called repurchase agreements, are utilized by many financial institutions such as banks and money market funds.

A typical repo consists of the sale of an asset and a contract to purchase the asset back at a slightly higher price at a later time. At the outset of the repo, the seller receives the cash. Thus, the seller is like the borrower in a collateralized with security such as government bonds and tranches of securitizations loan transaction.

On the other hand, the purchaser of the security who gives the cash at the outset of the repo receives a higher sum at the end of the period of the repo is considered a lender in the context that money received consists of the principal and the interest. With higher lower quality collateral, then it implies a higher lower haircut. Haircut, in this case, refers to the percentage decrease from the initial cash that the lender is willing to give to the borrower.

Haircut protects the lender from receiving less than full value in case the borrower defaults and the lender is forced to sell the collateral in case of default. The insecure commercial paper C. On the other hand, in Asset-backed commercial paper ABCP , the issuer provides the finance to buy assets by issuing a C.

In the years preceding the financial crisis, there was a high demand for collateral due to the growth of the OTC derivatives markets and increased dependence on short-term collateralizations by the financial institutions.

However, these demands were quenched by the issuance of the AAA-rated securitization tranches. The Fed statistics showed that the repos increased from USD 1. The SIVs were funded using short-term debt and depended on its flexibility to roll over short-term debt to finance their longer-dated assets. When collateralized mortgages began to lose value, the credit quality of numerous SIVs and increased doubt on the collateral value prevented an increasing number of SIVs from rolling over their ABCP and accompanied a decrease in liquidity in the subprime-related asset markets.

In fact, before mid, counterparty credit was not priced by the market since there was a significant difference between the unsecured overnight index swap OIS rate all periods swap rates. From June , the market participants started to worry about the collateralized securities and the level of exposure of the financial institutions to the subprime market leading to a sharp increase in the OIS-swap spread which remained high during the crisis and increased again when the Lehman Brother failed and did not return to the pre-crisis period.

Additionally, the credit spread on credit assets led to a significant decrease in credit assets. By the summer of , the short-term wholesale funding market began to freeze which included both the ABCP and repo markets. At this point, the investors halted the rolling over of maturing ABCP forcing the banks to recall the SIV assets onto their balance sheets.

With the increasing repo haircuts, the financial institutions that relied on the repo financing were unable to roll over their short-term funding, and thus, they were faced with three choices: merger, bailout or bankruptcy. The amplified uncertainty over the valuation of the asset-backed structured products worsened the financial crisis in the short-term debt markets.

This was because the valuation of the asset-backed structured products was difficult. The liability model and cashflow waterfalls were complicated and contained numerous types of collateral and interest rate triggers because, despite that, they have the same securitization structure. There was also the need for the pools of the collateral to be valued.

For instance, for ABS trust, it was necessary to calculate thousands of subprime mortgages with different borrower features and loan terms. The cashflows to some trusts depended on the future values and credit ratings of the collateral, which made modeling the cashflows a complicated undertaking. Moreover, this was worsened by insufficient data on different asset pools presents a challenge even to sophisticated investors. On the transparency issue, some of the seemingly complicated investors lacked the in-house skills to comprehend the complex products they were purchasing.

Moreover, they did have enough knowledge of the underlying risks that might arise from the assumptions they implied in calculating and credit rating models. Thus, many investors relied on credit rating agencies for their risk measurement. The computation of illiquid assets was blurry due to the lack of readily available reference prices, which made the investors be highly doubtful of the displayed prices when analyzing the credit risk of a counterparty.

The potent mixture of uncertainty and lack of transparency catalyzed the subprime crisis in the summer of because the market was skeptical that the past-issued structured products might be mispriced. There was also some anxiety on the exposure of financial institutions to the subprime market. For instance, Bear Sterns tried to save two hedge funds that were e prone to subprime mortgage losses.

One of the primer brokers, Merrill Lynch, called back USD million underlying collateral but had a challenge in selling due to the illiquidity of the markets to some assets at that time. As a result of these events, the wholesale short-term funding collapsed effectively. The Federal Reserve Fed and other central banks globally devised liquidity injection services. In the time gap between and the end of , the Fed blocked some asset groups that were affected by financial crisis stress.

These actions by the Fed included:. Some of the notable government intervention in the U. Systemic risk can be defined as a risk that occurs in one firm or market and can be amplified to the other firms or broader markets.

As a result, the entire markets or economies can be exposed to the risk. Systematic risk played a significant role in worsening the financial crisis. The collateral quality in ABCP and repo markets reduces the default risk by the borrowers. Therefore, the lenders in the market should possess confidence in the type of collateral assets. However, during the financial crisis, the ABCP and the repo fell, lowering the confidence of the lenders in the collateral.

They were concerned that collateral contained subprime mortgages and the reliability of its valuation. Due to a lack of transparency, even the borrower with no prime exposure did not roll over their debt. The valuation of illiquid asset prices is challenging even in normal market conditions. For instance, in the summer of , when BNP Paribas failed to value its illiquid assets, numerous money market managers of the repo markets abandoned it and moved to Treasury bills.

When the ABCP and repos collapsed, many hedge funds failed to roll over the respective debt and were forced to sell assets, and because the funds hold broadly typed of assets, the impact was felt in many markets. For instance, the CDO market was subjected to selling pressure, evidenced by the liquidation of some assets at low prices.

Moreover, to close out some current positions, some funds sold high credit-rated assets and bought lower credit-rated assets that were sold at that time. Consequently, the prices for quality assets fell, and that of lower quality rose affecting the hedge funds traded on pricing patterns.

Moreover, banks started to hoard some cash due to the uncertainty of seeming reductions on the decreasing credit lines of SIVs. The refusal to lend became popular among the banks due to the stricter standard. This negatively affected the hedge funds and other financial institutions, which tightened the availability of mortgages and restriction of business lending. This way, the financial crisis gave birth to an economic crisis!

The events that led to the Great Financial Crisis started with a downturn in the US subprime mortgage market in After completing this reading, you should be able to: Explain the arbitrage pricing Read More. After completing this reading, you should be able to: Explain modern portfolio theory After completing this reading, you should be able to: Describe the various types, After completing this reading, you should be able to: Describe the key features You must be logged in to post a comment.

After completing this reading, you should be able to: Describe the historical background and provide an overview of the — financial crisis. Describe the build-up to the financial crisis and the factors that played an important role. Explain the role of subprime mortgages and collateralized debt obligations CDOs in the crisis. Compare the roles of different types of institutions in the financial crisis, including banks, financial intermediaries, mortgage brokers and lenders, and rating agencies.

Describe trends in the short-term wholesale funding markets that contributed to the financial crisis, including their impact on systemic risk. Describe responses taken by central banks in response to the crisis. Overview and Timeline of the Crisis The start of the financial crisis was marked by runs in several short-term markets previously considered safe.

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How it Happened - The 2008 Financial Crisis: Crash Course Economics #12

The crisis sparked the Great Recession which resulted in increases in unemployment and suicide and decreases in institutional trust and fertility, among other. The Great Recession was a period of marked general decline (recession) observed in national economies globally that occurred between and Confidence in the financial sector collapsed and stock prices of financial institutions around the world plummeted. Banks were unable to sell most types of.