Global Financial Crisis

Meaning of Global Financial Crisis

The global financial crisis of 2008 is the worst of its kind since the

Great Depression Began with failures of large financial institutions in the United States and rapidly evolved into a global crisis resulting in a number of European bank failures Meaning of Global Financial Crisis The term financial crisis is applied broadly to a variety of situations Usually, some financial institutions or assets suddenly lose a large part of their value Banking Panics Stock market crashes Bursting of financial bubles Currency crisis Sovereign defaults

Banking Panics
Commercial banks suffer a sudden rush of withdrawals by depositors,

this is called a bank run Examples: September 7, 2008: Two United States Government sponsored enterprises (GSEs), Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation), into conservatorship run by FHFA (Fedral Housing Finance Agency) September 14, 2008 Lehman Brothers files for bankruptcy. Sale of Merrill Lynch to Bank of America September 16, 2008 AIG faces severe liquidity crunch

Financial institutions lost a large part of their value in days and weeks

The Figure on next slide shows it all!

Speculative Bubbles and Crashes

A bubble exists when the price of stock exceeds the value of the future income (such as interest or dividends) that would be received by owning it to maturity Wall Street Crash of 1929 Japanese property bubble of the 1980s Crash of the dot-com bubble in 2000-2001, and now the United States housing bubble.

The Causes
Proximate causes Sub-prime lending Originate and distribute model Financial engineering, derivatives Credit rating agencies Lax regulation Large global imbalances Fundamental cause Excessively accommodative monetary policy in the US and other advanced economies (2002-04)

THE MAJOR CAUSE OF CRISIS :THE SUB PRIMER:

How the Mortgage Crisis Happened?

ABC MORTGAGE BROKER

Id like to buy a house but I havent saved any money for a down payment and I dont think I can afford the monthly payments. Can you help me? Sure! Since the value of your house will always go up, we dont need down payment anymore

and we can give you a really low interest rate for few years. We will raise it later, okay

ABC MORTGAGE BROKER

Sure, no problem. Umm, theres one other thing my employer is a real problem and might not verify my employment. Would that be a problem?

No. We can get you a special Liars Loan and you can verify your own employment and income!

ABC MORTGAGE BROKER

You guys are wonderful! You are really willing to work with poor guys like me!!! Wow! Lets get started! Well, we dont actually lend you moneya bank will do thatso we dont really care if you repay the loan. We still get our commission.

XYZ BANK
A FEW WEEKS LATER , AT THE BANK..
Id better get rid of these worthless mortgage loans. They are starting to stink up my office. Thankfully the really smart guy in New York will buy them and perform their financial magic! I will call them right away!

Mortgage Files

INVESTMENT BANK OF WALL STREET

But who would buy this waste boss? Phew!! Wed better get rid of these mortgage before they start attracting files.

Mortgage Files

INVESTMENT BANK OF WALL STREET

But waste is a waste, isnt it? I dont get it. Ive got it! First we will create a new security and use these crappy mortgage as collateral. Well call it as CDO(or may be CMO). We can sell that CDO to investors and promise to pay them back as the mortgage are paid off.

Mortgage Files

INVESTMENT BANK OF WALL STREET

I still dont get it. Sure, individually these are pretty crappy loans, but if we pool them together only some of them will go bad- certainly not all of them. And since housing prices always go up, we really have very little to worry about. Mortgage Files

INVESTMENT BANK OF WALL STREET

But waste is a waste, isnt it? I dont get it.

Mortgage Files

The new CDO will work like this: It will be made up of three pieces(or trounches) and we will call them the Good, The Not-So-Good and The Ugly. If some of the mortgage fail, as surely some might, we will promise to pay investors holding the Good trounch first. Well pay the Not-SoGood investors second, and the Ugly investors last.

INVESTMENT BANK OF WALL STREET

Im starting to get it. And because the Good investors have the least risk, we will pay them a lower interest rate than the other guys, right? The Not-So-Goods will get a better interest rate and the Ugly guys will get a nice fat interest rate.

Mortgage Files

INVESTMENT BANK OF WALL STREET

Exactly. But wait, it gets better. We will buy bond insurance for the Good piece. If we do that, the Rating agencies will give it a really great rating, in the AAA to A range. They will likely give the Not-So-Good piece a BBB to B rating, still pretty good. We wont even bother asking them to rate the Uglypiece.

Mortgage Files

INVESTMENT BANK OF WALL STREET

So you have managed to create AAA and BBB securities out of a pile of worthless, risky mortgage loans. Boss you are a genius.

Yes I know.

Mortgage Files

INVESTMENT BANK OF WALL STREET

Okay, now who are we going to sell the three pieces to? Obviously the old fox at the SEC wont let us sell this stuff to widows and orphans, so we will sell it to our sophisticated institutional clients.

Mortgage Files

INVESTMENT BANK OF WALL STREET

So you have managed to create AAA and BBB securities out of a pile of worthless, risky mortgage loans. Boss you are a genius.

Like insurance companies, banks, small towns in Norway, school boards in Kansas to anyone who is looking for high quality safe investment.

Mortgage Files

INVESTMENT BANK OF WALL STREET

But surely nobody would buy the Ugly piece, would they? Of course not. nobody is that stupid!! We will keep that piece and pay ourselves a handsome interest rate.

Mortgage Files

INVESTMENT BANK OF WALL STREET

That is all great, but since we are only using the worthless mortgage as collateral on an entirely new security, we havent really gotten rid of them. Dont we have to show them on our balance sheet.

Mortgage Files

No, of course not. The REGULATORS allows us to set up a shell company in the Caymen Island to take ownership of the mortgages. The worthless mortgages goes on their balance sheet, not ours. The fancy name for it is Special Purpose Vehicle or SPV. And we call this entire process Securitization.

No Body saw it coming. The onset of crisis!!!!!

NORWEGIAN VILLAGE PENSION FUND

INVESTMENT BANK OF WALL STREET

It seems that the one who originally took out the house mortgage backing your CDOs are not able to payback.

Hey, Man! What is going on? I m not getting my monthly interest payments.

NORWEGIAN VILLAGE PENSION FUND

INVESTMENT BANK OF WALL STREET

Well the loans have turned bad. Frankly I am as disappointed as you are!

Wait a minute. We bought a AAA rated good piece of security. The safest one. So we ought to be paid FIRST.

NORWEGIAN VILLAGE PENSION FUND

INVESTMENT BANK OF WALL STREET

Yeah! That was the bad assumption. We are really very sorry for your loss.

Well, but you told me that housing prices always go up and your borrowers could always refinance their mortgages.

NORWEGIAN VILLAGE PENSION FUND

INVESTMENT BANK OF WALL STREET

The Rating Agency, the bank and we, all have gone bankrupt!

Bad assumption s! But what about the AAA rating from the rating agency?

NORWEGIAN VILLAGE PENSION FUND

INVESTMENT BANK OF WALL STREET

Havent you heard that AIG has also gone bankrupt.

But this security was insured. Isnt it? What about the insurer??

NORWEGIAN VILLAGE PENSION FUND

INVESTMENT BANK OF WALL STREET

Tell them, that now it is your turn to go bankrupt!

What a great story! Now, what should I tell my villagers??

Some definitions
A subprime mortgage is a type of loan granted to individuals with poor

credit histories , who, as a result of their deficient credit ratings, would not be able to qualify for conventional mortgages. Because subprime borrowers present a higher risk for lenders, subprime mortgages charge interest rates above the prime lending rate. These mortgages were Adjustable Rate Mortgages, meaning by, that initial interest rate were low and subsequently interest rate were increased. Toxic Asset is an asset that becomes illiquid when its secondary market disappears. Toxic assets cannot be sold, as they are often guaranteed to lose money. The term "toxic asset" was coined in the financial crisis of 2008/09, in regards to mortgage-backed securities, collateralized debt obligations and credit default swaps, all of which could not be sold after they exposed their holders to massive losses

COMPONENTS OF CRISIS

Components of the Crisis

Most of the crises over the past few decades have had

their roots in developing and emerging countries, often resulting from abrupt reversals in capital flows, and from loose domestic monetary and fiscal policies. In contrast, the current ongoing global financial crisis has had its roots in the US. The sustained rise in asset prices, particularly house prices, on the back of excessively accommodative monetary policy and lax lending standards during 20022006 coupled with financial innovations resulted in a large rise in mortgage credit to households, particularly low credit quality households.

Components of the Crisis

Most of these loans were with low margin money and with initial low

teaser payments. Due to the originate and distribute model, most of these mortgages had been securitized. In combination with strong growth in complex credit derivatives and the use of credit ratings, the mortgages, inherently sub-prime, were bundled into a variety of tranches, including AAA tranches, and sold to a range of financial investors. As inflation began to rise beginning 2004, the US Federal Reserve started to withdraw monetary accommodation. With interest rates beginning to rise, mortgage payments also started rising. Tight monetary policy contained aggregate demand and output, depressing housing prices.

Components of the Crisis

With low/negligible margin financing, there were

greater incentives to default by the sub-prime borrowers. Defaults by such borrowers led to losses by financial institutions and investors alike. Although the loans were supposedly securitized and sold to the off balance sheet special institutional vehicles (SIVs), the losses were ultimately borne by the banks and the financial institutions wiping off a significant fraction of their capital.

Components of the Crisis

Given the growing financial globalization, banks and financial

institutions in other major advanced economies, especially Europe, have also been adversely affected by losses and capital write-offs. Inter-bank money markets nearly froze and this was reflected in very high spreads in money markets. There was aggressive search for safety, which has been mirrored in very low yields on Treasury bills and bonds. These developments were significantly accentuated following the failure of Lehman Brothers in September 2008 and there was a complete loss of confidence.

References
Borio, C. (2008). The financial turmoil of 2007: A preliminary assessment and some policy considerations, Bank for International Settlements, Working Paper No. 251. Congressional Oversight Panel (2009), Special Report on Regulatory Reform. Mohan, Rakesh (2009), Mitigating Spillovers and Contagion Lessons from the Global Financial Crisis, Speech at the International Chambers of Commerce at New Delhi on January 16 UNCTAD (2009) The Global Economic Crisis: Systemic Failures and Multilateral Remedies, Report by the UNCTAD Secretariat Task Force on Systemic Issues and Economic Cooperation, Geneva.