Global Financial Crisis.

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?

I’d like to buy a house but I haven’t saved any money for a down payment and I don’t think I can afford the monthly payments. Can you help me?

Sure! Since the value of your house will always go up, we don’t 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, there’s 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 “Liar’s

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!

Let’s get started!

Well, we don’t actually lend

you money—a bank will do that—so we don’t really care if you

repay the loan. We still get our commission.

ABC MORTGAGE BROKER

A FEW WEEKS LATER , AT THE BANK………..

Mortgage Files

I’d 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!

XYZ BANK

But who would buy this waste

boss?

Phew!! We’d better get rid of these mortgage before they start attracting files.

Mortgage Files

INVESTMENT BANK OF WALL STREET

But waste is a waste, isn’t it? I

don’t get it.I’ve got it! First we will create a new security and use

these crappy mortgage as

collateral. We’ll 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


I still don’t 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


But waste is a waste, isn’t it? I

don’t get it.

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.

We’ll pay the “Not-So-Good investors second, and the “Ugly” investors

last.Mortgage Files


I’m 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


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

won’t even bother asking them to rate the “Ugly”piece.

Mortgage Files


So you have managed to create AAA and BBB securities out of a pile of worthless, risky mortgage

loans. Boss you are a genius.

Mortgage Files


Yes I know.

Okay, now who are we going to sell the three pieces to?

Mortgage Files


Obviously the ‘old fox’ at the SEC won’t let

us sell this stuff to

widows and orphans, so we will sell it

to our sophisticated institutional

clients.

So you have managed to create AAA and BBB securities out of a pile of worthless, risky mortgage

loans. Boss you are a genius.

Mortgage Files


Like insurance companies, banks, small

towns in Norway, school boards in

Kansas – to anyone who is looking for high

quality safe investment.

But surely nobody would buy the “Ugly” piece, would they?

Mortgage Files


Of course not. nobody is that

stupid!! We will keep that

piece and pay ourselves a

handsome interest rate.


That is all great, but since we are only using the worthless mortgage as collateral on an entirely

new security, we haven’t really gotten rid of them. Don’t 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!!!!!

Hey, Man! What is

going on?I m not

getting my monthly interest

payments.

It seems that the one who originally took out the house

mortgage backing your CDOs are not able to payback.

INVESTMENT BANK OF WALL STREETNORWEGIAN VILLAGE PENSION FUND

Wait a minute. We

bought a “AAA”

rated good piece of security.

The safest one. So we ought to be

paid FIRST.

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

you are!


Well, but you told me

that housing prices

always go up and

your borrowers

could always

refinance their

mortgages.

Yeah! That was the bad assumption. We are really very

sorry for your loss.


Bad assumptions! But what about the

“AAA” rating from the rating agency?

The Rating Agency, the

bank and we, all have gone bankrupt!


But this security

was insured. Isn’t it?

What about the

insurer??

Haven’t you heard that

AIG has also gone

bankrupt.


What a great story! Now, what should I tell

my villagers??

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


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 2002-2006 coupled with financial innovations resulted in a large rise in mortgage credit to households, particularly low credit quality households.


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.


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.


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.

Global Financial Crisis.

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global financial crisis

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