financial crisis+report

8/8/2019 Financial Crisis+REPORT

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PROJECT REPORT

ON

FINANCIAL CRISIS IN U.S.

SUBMITTED BY

ARUN PUNDIR

YAMINI BHUSHAN PANDEY

(FINANCIAL SERVICES)

SUBMITTED TO

PROF. MAHIMA SHARMA

JAIPURIA INSTITUTTE OF MANAGEMENT

LUCKNOW (U.P.)



Financial Crisis

The term financial crisis is applied broadly to a variety of situations inwhich some financial institutions or assets suddenly lose a large partof their value. In the 19th and early 20th with banking panics, andmany recessions coincided with these panics. Other situations that areoften called financial crises include stock market crashes and the bursting of other financial bubbles, currency crises, and sovereigndefaults centuries, many financial crises were associated

Many economists have offered theories about how financial crisesdevelop and how they could be prevented. There is little consensus,

however, and financial crises are still a regular occurrence around theworld.

Causes Of Financial Crisis

Strategic complementarities in financial markets

It is often observed that successful investment requires each investor in a financial market to guess what other investors will do. GeorgeSoros has called this need to guess the intentions of others'reflexivity'. Similarly, John Maynard Keynes compared financialmarkets to a beauty contest game in which each participant tries to predict which model other participants will consider most beautiful.

Furthermore, in many cases investors have incentivesto coordinate their choices. For example, someone who thinks other investors want to buy lots of Japanese yen may expect the yen to risein value, and therefore has an incentive to buy yen too. Likewise, adepositor in IndyMac Bank who expects other depositors to withdrawtheir funds may expect the bank to fail, and therefore has an incentiveto withdraw too. Economists call an incentive to mimic the strategiesof others strategic complementarity.



It has been argued that if people or firms have a sufficiently strongincentive to do the same thing they expect others to do, then self-fulfilling prophecies may occur. For example, if investors expect thevalue of the yen to rise, this may cause its value to rise; if depositors

expect a bank to fail this may cause it to fail.Therefore, financialcrises are sometimes viewed as a vicious circle in which investorsshun some institution or asset because they expect others to do so.

Leverage

Leverage, which means borrowing to finance investments, isfrequently cited as a contributor to financial crises. When a financialinstitution (or an individual) invests its own money, it can, in the very

worst case, lose its own money. But when it borrows in order to investmore, it can potentially earn more from its investment, but it can alsolose more than all it has. Therefore leverage magnifies the potentialreturns from investment, but also creates a risk of bankruptcy. Since bankruptcy means that a firm fails to honor all its promised paymentsto other firms, it may spread financial troubles from one firm toanother .

The average degree of leverage in the economy often rises prior to afinancial crisis. For example, borrowing to finance investment in

the stock market ("margin buying") became increasingly common prior to the Wall Street Crash of 1929.

Asset-liability mismatch

Another factor believed to contribute to financial crises is asset-liability mismatch, a situation in which the risks associated with aninstitution's debts and assets are not appropriately aligned. For example, commercial banks offer deposit accounts which can be

withdrawn at any time and they use the proceeds to make long-termloans to businesses and homeowners. The mismatch between the banks' short-term liabilities (its deposits) and its long-term assets (itsloans) is seen as one of the reason bank runs occur (when depositors panic and decide to withdraw their funds more quickly than the bank can get back the proceeds of its loans). Likewise, Bear Stearns failed



in 2007-08 because it was unable to renew the short-term debt it usedto finance long-term investments in mortgage securities.

In an international context, many emerging market governments areunable to sell bonds denominated in their own currencies, and

therefore sell bonds denominated in US dollars instead. Thisgenerates a mismatch between the currency denomination of their liabilities (their bonds) and their assets (their local tax revenues), sothat they run a risk of sovereign default due to fluctuations inexchange rates.

R egulatory failures

Governments have attempted to eliminate or mitigate financial crises

by regulating the financial sector. One major goal of regulationis transparency: making institutions' financial situation publiclyknown by requiring regular reporting under standardized accounting procedures. Another goal of regulation is making sure institutionshave sufficient assets to meet their contractual obligations,through reserve requirements, capital requirements, and other limitson leverage.

Some financial crises have been blamed on insufficient regulation,and have led to changes in regulation in order to avoid a repeat. For example, the Managing Director of the IMF,Dominique Strauss-Kahn, has blamed the financial crisis of 2008 on 'regulatory failure toguard against excessive risk-taking in the financial system, especiallyin the US'.[17] Likewise, the New York Times singled out thederegulation of credit default swaps as a cause of the crisis.

However, excessive regulation has also been cited as a possible causeof financial crises. In particular, the Basel II Accord has beencriticized for requiring banks to increase their capital when risks rise,

which might cause them to decrease lending precisely when capital isscarce, potentially aggravating a financial crisis.

Fraud

Fraud has played a role in the collapse of some financial institutions,when companies have attracted depositors with misleading claims



about their investment strategies, or have embezzled the resultingincome. Examples include Charles Ponzi's scam in early 20th centuryBoston, the collapse of the MMM investment fund in Russia in 1994,and the scams that led to the Albanian Lottery Uprising of 1997.

Many rogue traders that have caused large losses at financialinstitutions have been accused of acting fraudulently in order to hidetheir trades. Fraud in mortgage financing has also been cited as one possible cause of the 2008 subprime mortgage crisis; governmentofficials stated on Sept. 23, 2008 that the FBI was looking into possible fraud by mortgage financing companies FannieMae and Freddie Mac, Lehman Brothers, and insurer AmericanInternational Group.

Contagion

Contagion refers to the idea that financial crises may spread from oneinstitution to another, as when a bank run spreads from a few banks tomany others, or from one country to another, as when currency crises,sovereign defaults, or stock market crashes spread across countries.When the failure of one particular financial institution threatens thestability of many other institutions, this is called systemic risk.

One widely-cited example of contagion was the spread of the Thaicrisis in 1997 to other countries like South Korea. However,economists often debate whether observing crises in many countriesaround the same time is truly caused by contagion from one market toanother, or whether it is instead caused by similar underlying problems that would have affected each country individually even inthe absence of international linkages.

R ecessionary effects

Some financial crises have little effect outside of the financial sector,like the Wall Street crash of 1987, but other crises are believed tohave played a role in decreasing growth in the rest of the economy.There are many theories why a financial crisis could have arecessionary effect on the rest of the economy. These theoretical ideasinclude the 'financial accelerator', 'flight to quality' and 'flight to



liquidity', and the Kiyotaki-Moore model. Some 'third generation'models of currency crises explore how currency crises and bankingcrises together can cause recessions.

Origin Of U.S.Crisis

Week of September 7, 2008

The United States director of the Federal Housing FinanceAgency (FHFA), James B. Lockhart III, on September 7, 2008

announced his decision to place two United States Governmentsponsored enterprises (GSEs), Fannie Mae (Federal NationalMortgage Association) and Freddie Mac (Federal Home LoanMortgage Corporation), into conservatorship run by FHFA.United States Treasury Secretary Henry Paulson, at the same pressconference stated that placing the two GSEs into conservatorshipwas a decision he fully supported, and said that he advised "thatconservatorship was the only form in which I would committaxpayer money to the GSEs." He further said that "I attribute theneed for today's action primarily to the inherent conflict andflawed business model embedded in the GSE structure, and to theongoing housing correction." The same day, Federal ReserveBank Chairman Ben Bernanke stated in support: "I stronglyendorse both the decision by FHFA Director Lockhart to placeFannie Mae and Freddie Mac into conservatorship and the actionstaken by Treasury Secretary Paulson to ensure the financialsoundness of those two companies."


Major financial firm crisis

On Sunday, September 14, it was announced that LehmanBrothers would file for bankruptcy after the Federal Reserve Bank declined to participate in creating a financial support facility for Lehman Brothers. The same day, the sale of Merrill



Lynch to Bank of America was announced. The beginning of theweek was marked by extreme instability in global stock markets,with dramatic drops in market values on Monday, September 15,and Wednesday, September 17. On September 16, the large

insurer American International Group (AIG), a significant participant in the credit default swaps markets suffered a liquiditycrisis following the downgrade of its credit rating. The FederalReserve, at AIG's request, and after AIG has shown that it couldnot find lenders willing to save it from insolvency, created a creditfacility for up to US$85 billion in exchange for an 79.9% equityinterest, and the right to suspend dividends to previously issuedcommon and preferred stock.

Money market funds insurance and short sales prohibitions

On September 16, the Reserve Primary Fund, a large moneymarket mutual fund, lowered its share price below $1 because of exposure to Lehman debt securities. This resulted in demandsfrom investors to return their funds as the financial crisismounted. By the morning of September 18, money market sellorders from institutional investors totalled $0.5 trillion, out of atotal market capitalization of $4 trillion, but a $105 billionliquidity injection from the Federal Reserve averted an immediate

collapse. On September 19 the U.S. Treasury offered temporaryinsurance (akin to FDIC insurance of bank accounts) to moneymarket funds. Toward the end of the week, short selling of financial stocks was suspended by the Financial ServicesAuthority in the United Kingdom and by the Securities andExchange Commission in the United States. Similar measureswere taken by authorities in other countries. Some restoration of market confidence occurred with the publicity surrounding effortsof the Treasury and the Securities Exchange Commission

Troubled Asset Relief Program

On September 19, 2008, a plan intended to ameliorate thedifficulties caused by the subprime mortgage crisis was proposed by the Secretary of the Treasury, Henry Paulson. He proposed a Troubled Asset Relief Program, later incorporatedinto the Emergency Economic Stabilization Act of 2008,



which would permit for the United States government to purchase illiquid assets, also termed toxic assets, fromfinancial institutions. The value of the securities is extremelydifficult to determine.

Consultations between the Secretary of the Treasury,the Chairman of the Federal Reserve, and the Chairman of the U.S. Securities and Exchange Commission, Congressionalleaders and the President of the United States moved forward plans to advance a comprehensive solution to the problemscreated by illiquid mortgage-backed securities. At the close of the week the Secretary of the Treasury and President Bushannounced a proposal for the federal government to buy up toUS$700 billion of illiquid mortgage backed securities with the

intent to increase the liquidity of the secondary mortgagemarkets and reduce potential losses encountered by financialinstitutions owning the securities. The draft proposal of the plan was received favorably by investors in the stock market.Details of the bailout remained to be acted upon by Congress.


On Sunday, September 21, the two remaining investment banks, Goldman Sachs and Morgan Stanley, with the approval

of the Federal Reserve, converted to bank holding companies,a status subject to more regulation, but with readier access tocapital. On September 21, Treasury Secretary HenryPaulson announced that the original proposal, which wouldhave excluded foreign banks, had been widened to includeforeign financial institutions with a presence in the US. TheUS administration was pressuring other countries to set upsimilar bailout plans.

On Monday and Tuesday during the week of September 22,appearances were made by the Secretary of the Treasury andthe Chairman of the Board of Governors of the FederalReserve before Congressional committees and on Wednesdaya prime time presidential address was delivered by thePresident of the United States on television. Behind thescenes, negotiations were held refining the proposal which had



grown to 42 pages from its original 3 and was reported toinclude both an oversight structure and limitations onexecutive salaries, with other provisions under consideration.

On September 25, agreement was reported by congressional

leaders on the basics of the package; however, general andvocal opposition to the proposal was voiced by the public. OnThursday afternoon at a White House meeting attended bycongressional leaders and the presidential candidates, JohnMcCain and Barack Obama, it became clear that there was nocongressional consensus, with Republican representatives andthe ranking member of the Senate BankingCommittee, Richard C. Shelby, strongly opposing the proposal. The alternative advanced by conservative House

Republicans was to create a system of mortgage insurancefunded by fees on those holding mortgages; as the workingweek ended, negotiations continued on the plan, which hadgrown to 102 pages and included mortgage insurance as anoption. On Thursday evening Washington Mutual, the nation'slargest savings and loan, was seized by the Federal DepositInsurance Corporation and most of its assets transferredto JPMorgan Chase. Wachovia, one of the largest US banks,was reported to be in negotiations with Citigroup and other

financial institutions.


Early into Sunday morning an announcement was made by theUnited States Secretary of the Treasury and congressionalleaders that agreement had been reached on all major issues:the total amount of $700 billion remained with provision for the option of creating a scheme of mortgage insurance.

It was reported on Sunday, September 28, that a rescue planhad been crafted for the British mortgage lender Bradford &Bingley. Grupo Santander, the largest bank in Spain, wasslated to take over the offices and savings accounts while themortgage and loans business would be nationalized.

Fortis, a huge Benelux banking and finance company was partially nationalized on September 28, 2008, with Belgium,



the Netherlands and Luxembourg investing a total of 11.2 billion euros (16.3 billion U.S. dollars) in the bank. Belgiumwill purchase 49% of Fortis's Belgian division, with the Netherlands doing the same for the Dutch division.

Luxembourg has agreed to a loan convertible into a 49% shareof Fortis's Luxembourg division.

It was reported on Monday morning, September 29,that Wachovia, the 4th largest bank in the United States,would be acquired by Citigroup.

On Monday the German finance minister announced a rescueof Hypo Real Estate, a Munich-based holding companycomprised of a number of real estate financing banks, but thedeal collapsed on Saturday, 4 October.

The same day the government of Icelandnationalized Glitnir, Iceland¶s third largest lender.

Stocks fell dramatically Monday in Europe and the US despiteinfusion of funds into the market for short term credit. In theUS the Dow dropped 777 points (6.98%), the largest one-day point-drop in history (but only the 17th largest percentagedrop).

The U.S. bailout plan, now named the Emergency EconomicStabilization Act of 2008 and expanded to 110 pages wasslated for consideration in the House of Representatives onMonday, September 29 as HR 3997 and in the Senate later inthe week. The plan failed after the vote being held open for 40minutes in the House of Representatives, 205 for the plan, 228against. Meanwhile US stock markets suffered steep declines,the Dow losing 300 points in a matter of minutes, endingdown 777.68, the Nasdaq losing 199.61, falling below the

2000 point mark, and the S.&P. 500 off 8.77% for the day. Bythe end of the day, the Dow suffered the largest drop in thehistory of the index. The S&P 500 Banking Index fell 14% onSeptember 29 with drops in the stock value of a number of US banks generally considered sound, including Bank of NewYork Mellon, State Street and Northern Trust; three Ohio



banks, National City, Fifth Third, and KeyBank were downdramatically.

On Tuesday, September 30, stocks rebounded but creditmarkets remained tight with the London Interbank Offered

Rate (overnight dollar Libor) rising 4.7% to 6.88%.On Tuesday, September 30, 9 billion was made available bythe French, Belgian and Luxembourg governments to theFrench-Belgian bank Dexia.

After Irish banks came under pressure on Monday, September 29, the Irish government undertook a two year "guaranteearrangement to safeguard all deposits (retail, commercial,institutional and inter-bank), covered bonds, senior debt and

dated subordinated debt (lower tier II)" of 6 Irish banks: AlliedIrish Banks, Bank of Ireland, Anglo Irish Bank, Irish Life andPermanent, Irish Nationwide and the EBS Building Society;the potential liability involved is about 400 billion dollars.

The United States Senate's version of the $700 billion bailout plan, HR1424, modified to expand bank deposit guarantees to$250,000 and to include $100 billion in tax breaks for businesses and alternative energy, passed with bi-partisansupport 74-25 on October 1st. Reaction in the House was

mixed, but in a vote on Friday the House of Representatives passed the Emergency Economic Stabilization Act of 2008, asrefashioned by the Senate, 263-171 in a bipartisan vote.

Discussions were ongoing in Europe regarding possibleremedies for financial instability in Europe leading up to aconference Saturday afternoon in Paris hosted by NicolasSarkozy, president of France. UniCredit of Italy was reportedto be the latest bank to come under pressure. During the night

of October 2 Greece followed Ireland's lead and guaranteed all bank deposits.

On October 3 it was reported that Wachovia had rejected the previous offer from Citigroup in favor of acquisition by WellsFargo,[64] resulting in a legal dispute with Citigroup.



In Britain, the Financial Services Authority announced onOctober 3 that effective Tuesday, October 7, the amount of theguarantee of bank deposits would be raised to £50,000 from£35,000. On Friday, October 3, the government of the

Netherlands took over the Dutch operations of Fortis,replacing the bailout plan of September 28.

Week of October 5

Over the weekend and on Monday a major banking andfinancial crisis emerged in Iceland with its currency the krona,dropping 30% against the euro. At a meeting on Monday nightemergency legislation was passed granting broad powers tothe government to seize and regulate banks.

The Landsbanki and Glitnir were seized, while Kaupthing wassubjected to a rescue plan.

On October 6, the Icelandic Financial SupervisoryAuthority decided temporarily to suspend from trading onregulated markets all financial instruments issued by Glitnir banki hf., Kaupþing banki hf., Landsbanki Íslandshf., Straumur-Burðarás fjárfestingarbanki hf., Spron hf.,and Exista hf.[70]

Before the opening of the business day, October 6. BNPParibas, the French bank, assumed control of the remainingassets of Fortis following Dutch nationalization of theoperations of the bank in The Netherlands. Denmark, Austria,and possibly Germany, joined Ireland and Greece inguaranteeing bank deposits on Monday, October 6. Followingthis, the FTSE100 index of leading British shares took itsworst one-day hit in history. A banking Bill easing rescues isslated for introduction in the British Parliament on Tuesday,

October 7. On 6 October German chancellor AngelaMerkel pledged that the government would guarantee allGerman private bank savings. The government alsoannounced a revised bailout plan for German mortgagelender Hypo Real Estate (HRE). On Monday, October 6, theDow Jones Industrial Average closed below 10,000, a drop of 30% from its high above 14,000 a year earlier on October 9,



2007. In Brazil and Russia trading was suspended on Mondayfollowing dramatic drops in their markets.

On October 7, the Icelandic Financial SupervisoryAuthority took control of Landsbanki. On the same day,

the Central Bank of Iceland announced that Russia had agreedto provide a four-billion-euro loan, however this was soondenied by Russian authorities, and the Icelandic FinanceMinister had to correct the earlier announcement and nowstated that discussions had been initiated with Russia on providing a loan to Iceland. This was also denied by RussianDeputy Finance Minister Dmitry Pankin. Late in the evening,however, Russia's Finance Minister Alexei Kudrin didconcede that a request had been received, to which Russia was

positive, and that discussions on financial matters would beconducted later in the week when an Icelandic delegation wasexpected to arrive in Moscow. Standard & Poor's also cutIceland's foreign-currency sovereign credit rating from A-/A-2to BBB/A-3 and local-currency sovereign credit rating fromA+/A-1 to BBB+/A-2. S&P also lowered Iceland's bankingindustry country risk assessment from group 5 to group 8,worrying that "In a severe recession scenario, the cumulativeamount of nonperforming and restructured loans could reach

35% to 50% of total outstanding loans in Iceland.On October 7 the Federal reserve announced formation of aCommercial Paper Funding Facilty (CPFF) which will serveas a funding backstop to facilitate the issuance of termcommercial paper by eligible issuers. Several countriesannounced new or increased deposit guarantees: Taiwanoutlined plans to double the guarantee to NT$3 million($92,000) and the European Union agreed to increase

guarantees across the EU to at least ¼50,000 per saver. SeveralEU states then announced increases on top of thisminimum: Netherlands, Spain,Belgium, and Greece eachannounced they would guarantee up to ¼100,000.

The government of Britain announced on the morning of Wednesday, October 8 that it would make £25 billion



available as "Tier 1 capital" (preference share capital or "PIBS" [Permanent Interest-Bearing Securities]) to thefollowing financialinstitutions: Abbey, Barclays, HBOS, HSBC Bank plc, Lloyds

TSB, Nationwide Building Society, Royal Bank of Scotland,andStandard Chartered as part of a bank rescue package. Anadditional £25 billion was scheduled to be made available toother financial institutions, including British subsidiaries of foreign banks. "In reviewing these applications theGovernment will give due regard to an institution's role in theUK banking system and the overall economy". The planincluded increased ability to borrow from the government,offered assistance in raising equity, and a statement of support

for international efforts. The plan has been characterized as partial nationalization.

On Wednesday, October 8, the European Central Bank, Bank of England, Federal Reserve, Bank of Canada, SwedishRiksbank and Swiss National Bank all announcedsimultaneous cuts of 0.5% to their base rates at 11:00UTC. Shortly afterwards, the Central Bank of the People'sRepublic of China also cut interest rates. On October 8 therewere sharp losses on stock markets worldwide with a loss of

over 9% in Japan. Trading was suspended in Russia andIndonesia after steep morning losses. In the United States,following the funds cut by the Federal Reserve, stocks werevolatile, finishing down. On October 8 the Federal Reserveloaned AIG $37.8 billion, in addition to the previous loan of $85 billion.

On Wednesday night, October 8, the Central Bank of Iceland abandoned its attempt to peg the Icelandic króna at

131 króna to the euro after trying to set this peg on Monday,October 6. By Thursday October 9, the Icelandic króna wastrading at 340 to the euro when the government suspended alltrade in the currency.

On Thursday, October 9, the Icelandic Financial SupervisoryAuthority took control of the country's biggest bank Kaupþing



banki hf. This occurred when the Kaupthing Board resignedand asked the national authorities to take control. This cameabout when "Britain transferred control of the businessof Kaupthing Edge, its Internet bank, to ING Direct and put

Kaupthing's UK operations into administration" placing Kaupthing in technical default according to loanagreements. This marked an escalating row between Iceland and the United Kingdom over the growingcrisis. All trade was also suspended on the Iceland Stock Exchange until Monday October 13.

On Thursday, October 9, the one-year anniversary of the Dow's peak, the cost of short term credit rose while therewere heavy losses in the United States stock market;

the Dow dropped below 8600, reaching a five year low. It wasthe first time since August 2003 that the Dow closed below9000; losses were moderate in Europe. The following day,Friday, October 10, there were large losses in Asian andEuropean markets Yamato Life filed for bankruptcy. Beset byfalling commodities prices, Russia's stock markets remainedclosed on October 10. The Russian Parliament passed a planauthorizing lending of $36 billion gained from global oil salesto banks which met creditworthiness requirements. Special

attention is being paid to shoring up Rosselkhozbank, the bank which provides credit to the reviving agricultural sector. Theamount of funds available is limited due to falling oil prices. The government of the United States, as authorized by the Emergency Economic Stabilization Act, announced plans to infuse funds into banks by purchasing equity interestsin them, in effect, partial nationalization, as done in Britain.The Treasury secretary Henry M. Paulson Jr. met Friday inWashington with world financial leaders. A meeting of international financial leaders hosted by President Bush at theWhite House in Washington is planned on Saturday to attemptto coordinate global response to the financial crisis. Theannual meetings of both the International Monetary Fund andWorld Bank was scheduled to be held in Washington over thatweekend.



On Friday, October 10th, stock markets crashed across Europeand Asia. London, Paris and Frankfurt dropped 10% within anhour of trading and again when Wall Street opened for trading.Global markets have experienced their worst weeks since

1987 and some indexes, S&P 500, since the Wall Street Crashof 1929.

On October 10th, within the first five minutes of the tradingsession on Wall Street, the Dow Jones IndustrialAverage plunged 697 points, falling below 7900 to its lowestlevel since March 17, 2003. Later in the afternoon, the Dowmade violent swings back and forth across the breakeven line,toppling as much as 600 points and rising 322 points. TheDow ended the day losing only 128 points, or 1.49%. Trading

on New York Stock Exchange closed for the week with theDow at 8,451, down 1,874 points, or 18% for the week, andafter 8 days of losses, 40% down from its record high October 9, 2007. Trading on Friday was marked by extreme volatilitywith a steep loss in the first few minutes followed by a riseinto positive territory, closing down at the end of the day. InS&P100 some financial corporate showing signals upwardsalso. President George W. Bush reassured investors that thegovernment will solve the financial crisis gripping world

economies.The bonds of the bankrupt Lehman Brothers were auctionedon Friday, October 10. They sold for a little over 8 cents onthe dollar. Many of the bonds of Lehman Brothers wereinsured withcredit default swaps. There is apprehension that payments to the holders of Lehman bonds may severelydamage the firms or hedge funds which issued the swaps.Anticipated claims are estimated to be several hundred billion

dollars.As meetings proceeded with global financial leaders inWashington on Saturday, October 11, the United Statesgovernment announced a change in emphasis in its rescueefforts from buying illiquid assets to recapitalizing banks,including strong banks, in exchange for preferred equity; and



purchase of mortgages by Fannie Mae and Freddie Mac.These remedies can be put into effect quicker than the prior plan which was estimated to take a month to set intooperation.

Week of October 12

On Sunday the British government was in negotiations withRoyal Bank of Scotland, HBOS, Lloyds TSB and Barclays,major British banks, regarding recapitalization which wouldgive the British government a substantial equity interest. Aninvestment of more than 37 billion pounds is contemplated.Some purchases would be common stock with existingshareholders given a right of first refusal (the government

would only purchase the shares if existing shareholders didnot). Previously announced recapitalization planscontemplated only purchases of preferred equity withoutgovernment participation in governance of the banks,however, as the financial emergency has rapidly developed,more aggressive measures are being advanced. On Sunday,October 12, European leaders, meeting in Paris, led by Franceand Germany, announced recapitalization plans for Europe's banks. Plans were announced to guarantee bank deposits for

five years. European countries would finance their own rescue plans and tailor them to local conditions. Mechanisms are also planned to increase the availability of short term credit. Thetotal rescue plan totaled 1 trillion euros. Australia and NewZealand also announced bank guarantee plans. On Monday,October 13, the markets were closed in Japan and the bondmarket was closed in the United States.

On Sunday, in Norway, which is not in the euro zone,the Norwegian cabinet in a hastily called press conferenceannounced a US$57.4 billion (350 billion Norwegian kroner) plan of offering Norwegian banks new government bonds.This came three days ahead of Wednesday's hastened interestrate meeting at Norges Bank to decide whether or not toannounce rate cuts similar to the coordinated cuts of October 8. Central bank Governor Svein Gjedrem also made critical



billion of guarantees for new debt issued by commercial banksin 2008. This plan followed a meeting at the eurozone summitover the weekend to try to develop a coordinated effort tocombat the credit crisis. The UK government started the

nationalization process by injecting £37 billion in the nation¶sthree largest banks. The UK government would end upowning a majority share in the Royal Bank of Scotland (RBS)and over a 40% share in Lloyds and HBOS. In return for the bailout, the banks agreed to cancel dividend payments untilthe loans are repaid, have board members appointed by theTreasury, and limit executive pay. The European Central Bank attempted to revive credit market by weekly injections of unlimited euro funds at an interest rate of 3.75%. The ECB

president, Jean-Claude Trichet, was also contemplatingrelaxing the collateral standards to make the funds moreaccessible to banks. Following its European partners, Italy pledged to intervene as necessary to prevent any bank failuresin its country. Finance minister, Giulio Tremonti, said Italywould guarantee new bank bonds of up to 5 years until the endof 2009 and the Bank of Italy would provide ¼40 billion intreasury bills to banks to refinance inferior assets that can not be currently used as collateral. In coordination with other

eurozone countries, the Dutch government announced that itwould guarantee interbank lending up to ¼200 billion. Thisfollowed the set up of a ¼20 billion Dutch fund to helprecapitalize banks and insurers.

On Tuesday the United States announced a plan to take anequity interest of $250 billion in US banks with 25 billiongoing to each of the four largest banks. The 9 largest banks inthe US: Goldman Sachs, Morgan Stanley, J.P. Morgan, Bank of America, Merrill Lynch, Citigroup, Wells Fargo, Bank of New York Mellon and State Street were called in to a meetingon Monday morning and pressured to sign; all eventuallyagreed. The plan will be open to any bank for 30 days. Theequity interests purchased by the government are preferredshares that pay 5% but rise to 9% after 5 years; it is expectedthat the companies will repurchase this interest when they can



raise private capital to do so. The plan also includes an optionallowing the government to purchase common stock accordingto a formula which could return substantial profit to thetaxpayers should the stock price of the companies

substantially appreciate. The total liability assumed is $2.25trillion including a $1.5 trillion guarantee of new senior debtissued by banks and a $500 billion guarantee of deposits innoninterest-bearing accounts (business accounts used to paycurrent obligations such as payroll). The theory is that withadditional capitalization and the guarantees, banks will bewilling to resume a normal lending pattern with each other and borrowers.

Also on that day, United Arab Emirates¶ (UAE) ministry of

finance added a $19 billion liquidity injection to domestic banks bringing the total dollars injected to $32.7 billion. TheUAE central bank offered 13.6 billion in liquidity to helpdomestic banks in September. To protect local deposits, theUAE government guaranteed all deposits and interbank lending. Japan announced a plan that will help steady theJapanese market and avoid the worse of the credit crisis.Among the measures included are lifting restrictions oncompanies buying back their shares, strengthening disclosure

on short selling, and the temporary suspension of the sale of government-owned stocks. The Australian governmentunveiled a $10.4 billion stimulus package. The EconomicSecurity Strategy is designed to help pensioners, low andmiddle income families, and first time home buyers withstandthe credit crisis and global economic slowdown. This followedthe Australian government announcing that it would guaranteeall bank deposits for three years, guarantee all termwholesaling funding by Australian banks in internationalmarkets and double its planned purchase of residentialmortgage backed securities. The Icelandic stock exchange began trading again after a three day shutdown. The openingdid not include Iceland¶s three largest banks which werenationalized last week.



On Wednesday, October 15, the London stock exchange FTSE100 fell substantially, surrendering over 314 points to slipdown 7.16 percent. The losses precipitated more losses in theU.S., as the Dow Jones Industrial Average suffered its largest

drop in terms of percentage since 1987, falling over 733 points. The NASDAQ plunged almost eight and a half percent,and theStandard & Poor collapsed down over nine percent.

On October 16, a rescue plan was announced for the Swiss banks UBS and Credit Suisse. Recapitalization involved Swissgovernment funds, private investors, and the sovereign wealthfund of Qatar. A Swiss agency was set up to purchase andworkout toxic funds. UBS had suffered substantialwithdrawals by domestic Swiss depositors but still reported

profits; Credit Suisse has reported losses. Most large banks inthe United States continued to report large losses.

Week of October 19

On Sunday, October 19 the government of the Netherlands bailed out ING, the Dutch bank, with a ¼10 billion capitalrescue plan. On Monday the government of Belgium rescuedthe insurance company Ethias with a ¼1.5 billion capitalinjection. In Germany BayernLB has decided to apply for

funds from the German ¼500 billion rescue program. Swedenannounced formation of a 1.5 trillion kronor fund to supportinter-bank lending and a 15 billion kronor capital injection plan. Swedish banks were reported to be increasingly affected by the financial crisis. An IMF rescue plan for Iceland wasreported to be near finalization while Ukraine was reported to be in discussions with the IMF. Iceland was reported to havealso received assistance from Denmark and Norway whileBritain has offered a loan to support compensation of Britishdepositors in failed Icelandic bank Landsbanki. On MondayFrance announced a ¼10.5 billion rescue plan for six of itslargest banks, including Crédit Agricole, BNP and SociétéGénérale.



IMPACT ON U.S.In the early months of 2008, many observers believed that aU.S. recession had begun. As a direct result of the collapse of Bear

Stearns, Global Insight increased the probability of a worse-than-expected recession to 40% (from 25% before the collapse). Inaddition, financial market turbulence signaled that the crisis will not be mild and brief.

Alan Greenspan, ex-Chairman of the Federal Reserve, stated in March2008 that the 2008 financial crisis in the United States is likely to be judged as the harshest since the end of World War II. A chief economist at Standard & Poor's, said in March 2008 he has a worst-case-scenario in which the country could endure a double-dip

recession in which the economy would briefly recover in the summer 2008. Under this scenario, the economy's total output, as measured bythe gross domestic product, would drop by 2.2 percentage points,making it the third worst recession in the post World War II period.

The former head of the National Bureau of Economic Research saidin March 2008 he believed the country was then in a recession, and itcould be a severe one. A number of private economists generally predicted a mild recession ending in the summer of 2008 when

the economic stimulus checks going to 130 million households started being spent. A chief economist at Moody's predicted in March 2008that policymakers would act in a concerted and aggressive way tostabilize the financial markets, and that then the economy wouldsuffer but not enter a prolonged and severe recession. It takes manymonths before the National Bureau of Economic Research-committee,the unofficial arbiter of when recessions begin and end, makes its ownruling.

According to numbers published by Bureau of Economic Analysis in

May 2008, the GDP growth of the previous two quarters was positive.As one common definition of a recession is negative economicgrowth for at least two consecutive fiscal quarters, some analystssuggest this indicates that the U.S. economy was not in a recession atthe time. However this estimate has been disputed by some analystswho argue that if inflation is taken into account, the GDP growth wasnegative for the past two quarters, making it a technical recession.In a



May 9, 2008, report, the chief North American economist for investment bank Merrill Lynch wrote that despite the GDP growthreported for the first quarter of 2008, "it is still reasonable to believethat the recession started some time between September and January",

on the grounds that the National Bureau of Economic Research's four recession indicators all peaked during that period.

New York's budget director concluded the state of New York wasofficially in a recession. Governor David Paterson called anemergency economic session of the state legislature for August 19 to push a budget cut of $600 million on top of a hiring freeze and a7 percent reduction in spending at state agencies already implemented by the Governor. An August 1 report, issued by economists with Wachovia, said Florida was officially in a

recession.White House budget director Jim Nussle said the U.S. avoided arecession following revised GDP numbers from the CommerceDepartment showing a 0.2 percent contraction in the fourth quarter of 2007 down from a 0.6 percent increase and a downward revision to0.9 percent from 1 percent in the first quarter of 2008. The GDP for the second quarter was placed at 1.9 percent below an expected2 percent. Martin Feldstein, who headed the National Bureau of

Economic Research until June and serves on the group's recession-dating panel, said he believed the U.S. was in a very long recessionand that there was nothing the Federal Reserve could do to change it.

In a CNBC interview at the end of July 2008 Alan Greenspan said he believed the U.S. was not yet in a recession, but that it could enter onedue to a global economic slowdown.

A study released by Moody's found two-thirds of the 381 largestmetropolitan areas in the United States were in a recession. The studyalso said 28 states were in recession with 16 at risk. The findings were based on unemployment figures and industrial production data.

It is important to point out that in March of 2008, Warren Buffettstated in a CNBC interview that by a "common sense definition", theU.S. economy is already in a recession. Warren Buffet has also statedthat the definition of recession is flawed and that it should be 3quarters of GDP growth that is less than population growth. However,



the U.S. only experienced two consecutive quarters of GDP growthless than population growth.

R ise in unemployment

On September 5, 2008, the United States Department of Labor issued

a report that its unemployment rate rose to 6.1%, the highest in fiveyears. The news report cited the Department of Labor reports andinterviewed Jared Bernstein, an economist:

The unemployment rate jumped to 6.1 percent in August, its highestlevel in five years, as the erosion of the job market accelerated over the summer. Employers cut 84,000 jobs last month, more thaneconomists had expected, and the Labor Department said that more jobs were lost in June and July than previously thought. So far,

605,000 jobs have disappeared since January. The unemploymentrate, which rose from 5.7 percent in July, is now at its highest levelsince September 2003. Jared Bernstein, economist at the EconomicsPolicy Institute in Washington, said eight months of consecutive joblosses had historically signaled that the economy was in a recession."If anyone is still scratching their head over that one, they can stop,"Mr. Bernstein said. Stocks fell after the release of the report, with theDow Jones industrials down about 100 points after about 40 minutesof trading.

"Job losses are still mild by recession standards, but the losses arerelentless and they are accumulating," said Bob Brusca of FAOEconomics. "If job growth had paced with population growth duringthis year, it would have meant 1.3 million new jobs would have beencreated. Instead 605,000 were lost. That means about 2 million fewer people are working than if the economy were on a steady path. Andthat's a big number." But while economists generally study the payroll

numbers most closely, it's the unemployment rate that registers withmost Americans when they think about the labor market.

Liquidity crisis

In early July, depositors at the Los Angeles offices of IndyMac Bank frantically lined up in the street to withdraw their money. On July 11,



IndyMac - the largest mortgage lender in the US - was seized byfederal regulators. The mortgage lender succumbed to the pressures of tighter credit, tumbling home prices and rising foreclosures. That daythe financial markets plunged as investors tried to gauge whether the

government would attempt to save mortgage lenders FannieMae and Freddie Mac. The two were placed into conservatorship onSeptember 7, 2008.

During the weekend of September 13±14, LehmanBrothers declared bankruptcy after failing to find a buyer, Bank of America agreed to purchase Merrill Lynch, the insurancecompany AIGsought a bridge loan from the Federal Reserve, and aconsortium of 10 banks created an emergency fund of at least$70 billion to deal with the effects of Lehman's closure,[37] similar to

the consortium put forth by J.P. Morgan during the stock market panicof 1907 and the crash of 1929. Stocks on "Wall Street" tumbled onSeptember 15.

On September 16, news emerged that the Federal Reserve may giveAIG an $85 billion (£48 billion) rescue package; on September 17,2008, this was confirmed. The terms of the rescue package were thatthe Federal Reserve would receive an 80% public stake in the firm.The biggest bank failure in history occurred on September 25 when JP

Morgan Chase agreed to purchase the banking assets of WashingtonMutual.

The year 2008 as of September 17 has seen 81 public corporations filefor bankruptcy in the United States, already higher than the 78 in2007. Lehman Brothers being the largest bankruptcy in U.S. historyalso makes 2008 a record year in terms of assets with Lehman's $691 billion in assets all past annual totals. The year also saw the ninth biggest bankruptcy with the failure of IndyMac Bank.

On September 29, Citigroup beat out Wells Fargo to acquire theailing Wachovia's assets will pay $1 a share, or about $2.2 billion. Inaddition, the FDIC said that the agency would absorb the company'slosses above $42 billion; in exchange they would receive $12 billionin preferred stock and warrants from Citigroup in return for assumingthat risk.



Bailout of U.S. financial system

On September 17, Federal Reserve chairman Ben Bernanke advisedSecretary of the Treasury Hank Paulson that a large amount of publicmoney would be needed to stabilize the financial system. Short

selling on 799 financial stocks was banned on September 19.Companies were also forced to disclose large short positions. TheSecretary of the Treasury also indicated that money market funds willcreate an insurance pool to cover themselves against losses and thatthe government will buy mortgage-backed securities from banks andinvestment houses. Initial estimates of the cost of the Treasury bailout proposed by the Bush Administration's draft legislation (as of September 19, 2008) were in the range of $700 billion to $1trillion U.S.dollars. President GeorgeW.Bush asked Congress on Sept

ember 20, 2008 for the authority to spend as much as $700 billion to purchase troubled mortgage assets and contain the financialcrisis. The crisis continued when the United States House of Representatives rejected the bill and the Dow Jones took a 777 point plunge. A revised version of the bill was later passed by Congress, butthe stock market continued to fall nevertheless.

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