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2007–2008 financial crisis

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This article is about the series of financial market events, starting in July 2007, which suggested a weakening in the world economies. For details on the stock market crashes and bank bailouts of late 2008, see Global financial crisis of 2008. For economic issues beyond the financial markets, see Late 2000s recession.

The financial crisis of 2007–2008, initially referred to in the media as a "credit crunch" or "credit crisis", began in July 2007[1][2] when a loss of confidence by investors in the value of securitized mortgages in the United States resulted in a liquidity crisis that prompted a substantial injection of capital into financial markets by the United States Federal Reserve and the European Central Bank.[3][4] The TED spread, an indicator of perceived credit risk in the general economy, spiked up in July 2007, remained volatile for a year, then spiked even higher in September 2008,[5] reaching a record 4.65% on October 10, 2008. In September 2008, the crisis deepened, as stock markets world-wide crashed and entered a period of high volatility, and a considerable number of banking, mortgage and insurance company failures in the following weeks.

Share in GDP of US financial sector since 1860.[6]

Although America's housing collapse is often cited as having caused the crisis, the financial system was vulnerable because of intricate and over-leveraged financial contracts and operations, a U.S. monetary policy making the cost of credit negligible therefore encouraging such over-leverage, and generally an "hypertrophy of the financial sector"[7] (financialization).

One example was credit derivatives - Credit Default Swaps (CDS), which insure debt holders against default. They are fashioned privately, traded over the counter outside the purview of regulators.[8] The U.S. government's seizure of the mortgage companies prompted an auction of their debt so that traders who bought and sold default protection (CDS) could settle contracts. The auctions are used to set a price by which investors can settle the contracts with cash rather than having to physically deliver a bond to their counter-parties. Sellers of protection pay the face value of the contracts minus the recovery value set on the bonds.

Scope

After affecting banking and credit, mainly in the United States, the situation evolved into a global general financial crisis verging on a systemic crisis. Domino effect, as many institutions had financial links, and also psychological contagions (see behavioral finance), made it spread at the same time worldwide and to many financial and economic areas:

  • Financial markets (stock exchanges and derivative markets notably) where it developed into a market crash,
  • Various equity funds and hedge funds that went short of cash and had to get rid of assets,
  • Insurance activities and pension funds, facing a receding asset portfolio value to cover their commitments,
  • With also incidences on public finance due to the bailout actions.
  • Forex, at least for some currencies (Icelandic crown, various Eastern Europe and Latin America currencies...), and with increased volatility for most of them

The first symptoms of what is called the Economic crisis of 2008 ensued also in various countries and various industries, as the financial crisis, albeit not the only cause, was a factor by making borrowing and equity raising harder.

Historical background

The initial liquidity crisis can in hindsight be seen to have resulted from the incipient subprime mortgage crisis, with the first alarm bells being rung by the 2006 HSBC results. The crisis was widely predicted by a number of economic experts and other observers, but it proved impossible to convince responsible parties such as the Board of Governors of the Federal Reserve of the need for action.[9][10]

One of the first victims was Northern Rock, a major British bank.[11] The highly leveraged nature of its business led the bank to request security from the Bank of England. News of this lead to investor panic and a bank run in mid-September 2007. Calls by Liberal Democrat Shadow Chancellor Vince Cable to nationalise the institution were initially ignored, however in February 2008, the British Government relented, and the bank was taken into public hands. Northern Rock's problems proved to be an early indication of the troubles that would soon befall other banks and financial institutions.

Excessive lending under loosened underwriting standards, which was a hallmark of the United States housing bubble, resulted in a very large number of subprime mortgages. These high-risk loans had been perceived to be mitigated by securitization. Rather than mitigating the risk, however, this strategy appears to have had the effect of broadcasting and amplifying it in a domino effect. The damage from these failing securitization schemes eventually cut across a large swath of the housing market and the housing business and led to the subprime mortgage crisis. The accelerating rate of foreclosures caused an ever greater number of homes to be dumped onto the market. This glut of homes decreased the value of other surrounding homes which themselves became subject to foreclosure or abandonment. The resulting spiral underlay a developing financial crisis.

Initially the companies affected were those directly involved in home construction and mortgage lending such as Northern Rock and Countrywide Financial. Financial institutions which had engaged in the securitization of mortgages such as Bear Stearns then fell prey. Later on, Bear Stearns was acquired by JP Morgan Chase through the deliberate assistance from the US government. Its stock price fell from the record high $154 to $3 in reaction to the buyout offer of $2 by JP Morgan Chase, subsequently the acquisition price was agreed on $10 between the US government as well as JP Morgan. On July 11, 2008, the largest mortgage lender in the US, IndyMac Bank, collapsed, and its assets were seized by federal regulators after the mortgage lender succumbed to the pressures of tighter credit, tumbling home prices and rising foreclosures. That day the financial markets plunged as investors tried to gauge whether the government would attempt to save mortgage lenders Fannie Mae and Freddie Mac, which it did by placing the two companies into federal conservatorship on September 7, 2008 after the crisis further accelerated in late summer.

See also: Federal takeover of Fannie Mae and Freddie Mac

It then began to affect the general availability of credit to non-housing related businesses and to larger financial institutions not directly connected with mortgage lending. At the heart of many of these institution's portfolios were investments whose assets had been derived from bundled home mortgages. Exposure to these mortgage-backed securities, or to the credit derivatives used to insure them against failure, threatened an increasing number of firms such as Lehman Brothers, AIG, Merrill Lynch, and HBOS.[12][13][13][14] Other firms that came under pressure included Washington Mutual, the largest savings and loan association in the United States, and the remaining large investment firms, Morgan Stanley and Goldman Sachs.[15][16]

Risks and regulations

For some analysts the first half of the 2000 decade will be remembered as a time that financial innovations and the CRA requirement of mandated lending to non creditworthy individuals overwhelmed the capacity of both regulators and banks to assess risk in the financial markets. The case of Citigroup is emblematic: Citigroup had always been under Federal Reserve regulation, and its near collapse shows that the regulation was ineffective, and that government underestimated the crisis severity even after it began. Citigroup was not alone in not being capable to understand fully the risks it was taking. As financial assets became more and more complex, and harder and harder to value, investors were reassured by the fact that both the international bond rating agencies and bank regulators, who came to rely on them, accepted as valid some complex mathematical models which theoretically "showed" the risks were much smaller than they actually proved to be in practice [17]. In George Soros' opinion "The super-boom got out of hand when the new products became so complicated that the authorities could no longer calculate the risks and started relying on the risk management methods of the banks themselves. Similarly, the rating agencies relied on the information provided by the originators of synthetic products. It was a shocking abdication of responsibility" [18]

Developing global financial crisis

Main article: Global financial crisis of 2008
Dow Jones Industrial Average Jan 2006 - Nov 2008 [19]

Beginning with bankruptcy of Lehman Brothers on Sunday, September 14, 2008, the financial crisis entered an acute phase marked by failures of prominent American and European banks and efforts by the American and European governments to rescue distressed financial institutions, in the United States by passage of the Emergency Economic Stabilization Act of 2008 and in European countries by infusion of capital into major banks. Afterwards, Iceland almost claimed to go bankrupt. Many financial institutions in Europe also faced the liquidity problem that they needed to raise their capital adequacy ratio. As the crisis developed, stock markets fell worldwide, and global financial regulators attempted to coordinate efforts to contain the crisis. The US government composed a $700 billion plan to purchase unperforming collaterals and assets. However, the plan was vetoed by the US congress because some members rejected the idea that the taxpayers money be used to bail out the Wall Street investment bankers. The stock market plunged as a result, the US congress amended the $700 billion bail out plan and passed the legislation. The market sentiment continued to deteriorate and the global financial system almost collapsed. While the market turned extremely pessimistic, the British government launched a 500 billion pound bail out plan aimed at injecting capital into the financial system. The British government nationalized most of the financial institions in trouble. Many European governments followed suit, as well as the US government. Stock markets appeared to have stabilized as October ended. In addition, the falling prices due to reduced demand for oil, coupled with projections of a global recession, brought the 2000s energy crisis to temporary resolution.[20][21] In the Eastern European economies of Poland, Hungary, Romania, and Ukraine the economic crisis was characterized by difficulties with loans made in hard currencies such as the Swiss franc. As local currencies in those countries lost value, making payment on such loans became progressively difficult.[22]

As the financial panic developed during September and October, 2008 there was a "flight to quality" as investors sought safety in U.S. treasury bonds, gold, and strong currencies such as the dollar and the yen. This currency crisis threatened to disrupt international trade and produced strong pressure on all world currencies. The International Monetary Fund had limited resources relative to the needs of the many nations with currency under pressure or near collapse.[23]

Economic aspects and projections

Main article: Economic crisis of 2008

Global aspects

A number of commentators have suggested that if the liquidity crisis continues, there could be an extended recession or worse.[24] The continuing development of the crisis prompted fears of a global economic collapse.[25] The financial crisis is likely to yield the biggest banking shakeout since the savings-and-loan meltdown.[26] Investment bank UBS stated on October 6 that 2009 would see a clear global recession, with recovery unlikely for at least two years.[27] Three days later UBS economists announced that the "beginning of the end" of the crisis had begun, with the world starting to make the necessary actions to fix the crisis: capital injection by governments; injection made systemically; interest rate cuts to help borrowers. The United Kingdom had started systemic injection, and the world's central banks were now cutting interest rates. UBS emphasized the United States needed to implement systemic injection. UBS further emphasized that this fixes only the financial crisis, but that in economic terms "the worst is still to come".[28] UBS quantified their expected recession durations on October 16: the Eurozone's would last two quarters, the United States' would last three quarters, and the United Kingdom's would last four quarters.[29]

At the end of October UBS revised its outlook downwards: the forthcoming recession would be the worst since the Reagan recession of 1981 and 1982 with negative 2009 growth for the US, Eurozone, UK and Canada; very limited recovery in 2010; but not as bad as the Great Depression.[30]

US aspects

Real gross domestic product—the output of goods and services produced by labor and property located in the United States—decreased at an annual rate of 0.3 percent in the third quarter of 2008, (that is, from the second quarter to the third quarter), according to advance estimates released by the Bureau of Economic Analysis. In the second quarter, real GDP increased 2.8 percent. Real disposable personal income decreased 8.7 percent.[31]

Nouriel Roubini, professor of economics at New York University and chairman of RGE Monitor, predicted a recession of up to 2 years, unemployment of up to 9 percent, and another 15 percent drop in home prices.[32] Moody's Investors Service continued in October, 2008 to project increased foreclosures for residential mortgages originating in 2006 and 2007. These increases may result in downgrades of the credit rating of bond insurers Ambac, MBIA, Financial Guaranty Insurance Company, and CIFG.[33] The bond insurers, meantime, together with their insurance regulators, are negotiating with the Treasury regarding possible capital infusions or other relief under the $700 billion bailout plan. In addition to mortgage backed bonds, the bond insurers back hundreds of billions of dollars of municipal and other bonds. Thus a ripple effect could spread beyond the mortgage sector should there be a major downgrade in credit ratings or failure of the companies. [34]

Official prospects

On November 3, 2008, the EU-commission at Brussels predicted for 2009 an extremely weak growth of the BIP, by 0.1% only, for the countries of the Euro zone (France, Germany, Italy, etc.) and even negative number for the UK (-1.0%), Ireland and Spain. On November 6, the IMF at Washington, D.C., launched numbers predicting a worldwide recession by -0.3% for 2009, averaged over the developed economies. On the same day, the Bank of England and the Central Bank for the Euro zone, respectively, reduced their interest rates from 4.5% down to 3%, and from 3.75% down to 3.25%. Economically, mainly the car industry seems to be involved. As a consequence, starting from November 2008, several countries launched large "help packages" for their economies.

Timeline of events

Background

Events of 2007

  • Liquidity crisis emerges August 9, 2007[4][35][36]
  • Northern Rock sought and received a liquidity support facility from the Bank of England on September 14, 2007[37]
  • Record high US stock market October 9, 2007 Dow Jones Industrial Average (DJIA) 14,164[38]

Events of 2008

Main article: Economic crisis of 2008

See also

References

  1. ^ Wall Street Journal. "TED Spread spikes in July 2007". Wall Street Journal. {{cite web}}: Cite has empty unknown parameter: |1= (help)
  2. ^ Weblo. "Credit crisis - how it all began]The credit crisis first came to public attention in July 2007, with the bankruptcy of two massive Bear Stearns hedge funds - and the wiping out of over $1billion overnight". Weblo. {{cite web}}: Cite has empty unknown parameter: |1= (help)
  3. ^ Floyd Norris (August 10, 2007). "A New Kind of Bank Run Tests Old Safeguards". The New York Times.
  4. ^ a b Larry Elliott (August 5 2008). "Credit crisis - how it all began] Suddenly, one August day last year shook the world, turning an Edwardian summer of prosperity into a grim financial crisis". The Guardian. {{cite web}}: Check date values in: |date= (help)
  5. ^ "3 year chart" TED spread Bloomberg.com "Investment Tools"
  6. ^ Confer Thomas Philippon: "The future of the financial industry", Finance Department of the New York University Stern School of Business at New York University, link to blog [1]
  7. ^ For this term see: Arrighi, G., & Silver, B. J. (1999). Chaos and governance in the modern world system. Minneapolis: University of Minnesota Press. And: [2] John Bellamy Foster: Monopoly finance capital and the crisis. Interview with John Bellamy Foster for the Norwegian daily "Klassekampen", conducted on October 15, 2008.
  8. ^ ['How Credit Default Swaps Spread Financial Rot']
  9. ^ "Challenging the Crowd in Whispers, Not Shouts" commentary by Robert Shiller in The New York Times November 1, 2008
  10. ^ "In Modeling Risk, the Human Factor Was Left Out" article by Steve Lohr in The New York Times November 4, 2008
  11. ^ HM Treasury, Bank of England and Financial Services Authority (September 14, 2007). "News Release: Liquidity Support Facility for Northern Rock plc".
  12. ^ "Pain Spreads as Credit Vise Grows Tighter" article by Louis Uchitelle in The New York Times September 18, 2008
  13. ^ a b "Lehman Files for Bankruptcy; Merrill Is Sold" article by Andrew Ross Sorkin in The New York Times September 14, 2008
  14. ^ "Lloyds Bank Is Discussing Purchase of British Lender" article by Julia Werdigier in The New York Times September 17, 2008
  15. ^ "Washington Mutual Is Said to Consider Sale" article by Geraldine Fabrikant in The New York Times September 17, 2008
  16. ^ "As Fears Grow, Wall St. Titans See Shares Fall" article by Ben White and Eric Dash in The New York Times September 17, 2008
  17. ^ Floyd Norris (2008). News Analysis: Another Crisis, Another Guarantee, The New York Times, November 24, 2008
  18. ^ George Soros (2008) The worst market crisis in 60 years. London: The Financial Times, January 22 2008 19:57, last updated: January 22 2008 19:57
  19. ^ World-Crisis.net -- Global Financial Crisis - Dow Jones Industrial
  20. ^ "Forecast for Global Oil Demand Cut"
  21. ^ "Commodity Prices Tumble" article by Clifford Krauss in The New York TimesOctober 13, 2008
  22. ^ "`Panic' Strikes East Europe Borrowers as Banks Cut Franc Loans" article by Ben Holland, Laura Cochrane and Balazs Penz; Bloomberg, October 31, 2008
  23. ^ Landler, Mark (2008-10-24). "Dollar and Yen Soar as Other Currencies Fall and Stocks Slip". The New York Times. Retrieved 2008-10-25. {{cite news}}: Unknown parameter |coauthors= ignored (|author= suggested) (help)
  24. ^ "Credit Enters a Lockdown" "Economic memo" by Peter S. Goodman in The New York Times September 25, 2008
  25. ^ Cho, David (2008-10-07). "Unfolding Worldwide Turmoil Could Reverse Years of Prosperity". The Times. Retrieved 2008-10-07. {{cite news}}: Unknown parameter |coauthors= ignored (|author= suggested) (help)
  26. ^ Since 1934, FDIC has closed more than 3,500 banks. More than 82% failed during the savings-and-loan crisis (chart)."Bank on this: bank failures will rise in next year". Associated Press. 2008-10-05. {{cite news}}: Italic or bold markup not allowed in: |publisher= (help)
  27. ^ UBS AG. "Recession". There is no alternative. Daily roundup for 2008-10-06. Retrieved 2008-10-12. 'global growth at 2.2% yoy (previously 2.8%). The IMF brands 2.5% yoy a "recession".' 'global collapse is inevitable' ... 'at least two years before we can talk of a normalisation in economic activity'
  28. ^ UBS AG. A plan to save the world. Daily roundup for 2008-10-09. Retrieved 2008-10-13. "The actions yesterday can not stop a significant economic downturn."
  29. ^ UBS AG. Fears of recession loom. Daily roundup for 2008-10-09. Retrieved 2008-10-17. "short by historical standards"
  30. ^ UBS AG. Be afraid. Be very afraid. Daily roundup for 2008-10-31. Retrieved 2008-11-02. "NEGATIVE growth in 2009 for the US, UK, Euro area and Canada. Japan is the fastest growing G7 economy at 0.1% growth. Global growth in 2009 forecast at 1.3%."
  31. ^ News Release: Gross Domestic Product (GDP) 2008 (Advance)
  32. ^ Martin, Eric (2008-10-15). "Roubini Sees Worst Recession in 40 Years, Stock Drop (Update3)". Bloomberg. Retrieved 2008-10-15. {{cite news}}: Unknown parameter |coauthors= ignored (|author= suggested) (help)
  33. ^ van Duyn, Aline (2008-10-19). "Moody's lifts projections for mortgage losses". Financial Times. Retrieved 2008-10-21. {{cite news}}: Cite has empty unknown parameter: |coauthors= (help)
  34. ^ van Duyn, Aline (2008-10-21). "Bond insurers seek to tap into $700bn plan". Financial Times. Retrieved 2008-10-21. {{cite news}}: Cite has empty unknown parameter: |coauthors= (help)
  35. ^ "Big French Bank Suspends Funds", New York Times, 9 August 2007
  36. ^ "Dow Falls 387 Points on New Loan Fears"
  37. ^ "Bank of England". 2007-09-14. Retrieved 2008-02-20. {{cite web}}: Text "2007" ignored (help); Text "Liquidity Support Facility for Northern Rock plc - Tripartite Statement by HM Treasury, Bank of England and Financial Services Authority" ignored (help); Text "News" ignored (help); Text "Publications" ignored (help)
  38. ^ Chart of the Dow Jones Industrial Average
  39. ^ "Northern Rock to be nationalised". BBC News. 2008-02-17. Retrieved 2008-04-08.
  40. ^ World-Crisis.net -- Chart of the Dow Jones Industrial Average

The initial articles and some subsequent material were adapted from the Wikinfo article "Financial crisis of 2007-2008" http://www.wikinfo.org/index.php?title=Financial_crisis_of_2007-2008 released under the GNU Free Documentation License Version 1.2


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