the financial crisis- paper

The Financial Crisis Philippe De Smit

3rd Bachelor Commercial Engineer FUNDP 2008-2009

The Financial Crisis

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The Financial Crisis Philippe De Smit

3rd Bachelor Commercial Engineer FUNDP 2008-2009


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INDEX

I. Introduction ................................................................................................. 4

II. Causes of the current financial crisis .......................................................... 5

III. A timeline of the most important events..................................................... 8

IV. Fannie and Freddie.................................................................................... 11

V. The current financial crisis’ nature ........................................................... 13

VI. The great depression & lessons from the past .......................................... 14

VII. The Impact on Emerging Countries. ......................................................... 19

VIII. How to solve this problem ........................................................................ 24

IX. Executive Summary .................................................................................. 28

X. Sources ...................................................................................................... 29


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I. Introduction

“Fears drag down European markets”,” Pound tumbles to a five-year low”, “Credit crisis, world in turmoil”, etc. The major news-topic during last months was the Financial Crisis. All over the world, there are a lot of questions about the origins of this crisis.

In this paper I am going to explain to you what the financial crisis is. We are going to look for the origins of this crisis, but not for the responsibilities. I will make a comparison to previous major financial crises, shaping a view of which lessons we should have learned from the past. After that, we will look at the consequences this crisis has on the emerging countries’ economies.

A short definition of the financial crisis can be: “A loss of confidence in a country's currency or other financial assets causing international investors to withdraw their funds from the country”11 The current financial crisis can be defined as a situation in which a large part of financial institutions or assets suddenly lost a substantial chunk of their value. In the 19th and early 20th century, many financial crises were associated with banking panics and recessions coincided with these panics. Banking panics, recessions...these words still have their importance when we talk about the current financial crisis. But the current financial crisis is more complex: it is not just caused by recession or by banking panics, but also by the mania for home ownership, by speculative fever, by the crash of the dot-com bubble, by historically low interest rates and the risky mortgage products and by lax lending standards. Annex 1 gives an overview of the different events that caused the final financial crisis, while annex 4 gives a graphical overview.

I especially want to thank Jean Sanders (securities house Petercam) for supporting & advising me.

The Chinese use two brush strokes to write the word 'crisis'. One brush stroke stands for danger; the other for opportunity. In a crisis, be aware of the danger-but recognize the opportunity.

~ John F. Kennedy


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II. Causes of the current financial crisis

The crisis started in the US housing markets. The main problem was the lack of transparency in financial markets: there was no real control on new financial products such as mortgage-backed securities. Mortgage-problems became more apparent throughout 2007 and 2008.

For a number of years, a declined lending standard and an increase in loan incentives (such as easy initial terms, and a long-term trend of rising housing prices) had encouraged many good American house-father to assume (difficult) mortgages in the belief they would be able to quickly refinance at more favourable terms. A good example is the image everyone has of the American with a bunch of credit cards in his wallet: Americans don’t know how to save money, if they earn money; they want to spend it as soon as possible. Stronger, they even want to spend money they don’t even have, using their credit cards. The result? After a while they don’t know how to pay back all the interests on these loans... How bizarre, wasn’t it Thomas Jefferson –who partially designed the American declaration of independence– who told us: “never spend your money before you have it.”?

Once interest rates began to rise and housing prices started to drop moderately in 2007 in many parts of the U.S., refinancing became more difficult. Defaults and foreclosure activity increased dramatically as easy initial terms expired, home prices failed to go up as anticipated. Foreclosure is the legal and professional proceeding in which a mortgagee or a lender obtains a court ordered termination of a mortgagor's equitable right of redemption. Usually a lender obtains a security interest from a borrower who mortgages or pledges an asset like a house to secure the loan. If the borrower defaults and the lender tries to repossess the property, courts of equity can grant the owner the right of redemption if the borrower repays the debt.12 Foreclosures accelerated in the US in late 2006. During 2007, nearly 1.3 million U.S. housing properties were subject to foreclosure activity, up 79% from 2006.13

But how did this cause a global financial crisis?

The house market downturn was a risk to the broader economy because banks repacked these loans and mortgages in new financial products, generally called derivatives. These were bought by investors, investment banks, banks all over the world. So, where banks traditionally lent money to homeowners for their mortgage and retained the credit risk, now, banks can sell rights to the mortgage payments and related credit risk to investors, through a process called securitization (this due to financial innovations discussed above). These are called mortgage backed securities (MBO) and collateralized debt obligations (CDO). Banks offered an increasing array of higher-risk loans. Even if these high risk loans included the "No Income, No Job and no Assets" loans, the “No, No, No...”in this sentence didn’t preserve the lenders from taking these very high risks.

For example: you would like to buy the house of your dreams, but... you don’t have enough money. You go to your bank to ask for a loan. By using easy initial terms, American banks easily convinced customers to opt for this kind of housing-financement. The banks would

“The only reason I made a commercial for American Express was to pay for my American Express bill.", Peter Ustinov.


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“There are more fools among buyers than sellers” This old French proverb is based on a simple imbalance of knowledge. The trading of money and goods may seem simple, but the seller of the goods usually knows pretty much all there is to know about the object or asset he is parting with. The buyer usually knows less.

Anyone who's ever sold a car or house knows it's relatively easy to conceal a fault from the average buyer. Even if money is of a known and certain worth, the risk to make a bad choice persists...

Those who sell profitable shares too soon, only to see the price race away, can certainly be called foolish. Yet there are probably fewer of them than those who bought a share just before a profit warning.

Changes in US housing Prices,S&P/Case-Shiller Indices 1988-2008; update september 2008

collect several of these loans, repackage them and sell them to other banks, using these derivatives.

This new banking model means credit risk has been distributed broadly to investors, with a series of consequential impacts, so that the main problem is that banks were not aware of the risk they were taking. The moment interest rates began to rise and housing prices started to drop moderately, financing became difficult. Defaults and foreclosure activity increased dramatically. People didn’t know how to pay back, went bankrupt,... Banks didn’t really know what to do and began to make huge losses.

We have seen that mortgage-banks did “casino-banking” on a large-scale. Banks packed all kinds of assets under untransparent packages that were sold worldwide to other banks, investment funds and investors. Huge CDS and CDO markets were created. Banks made enourmous benefits selling these products. Some dealers and traders made astronomic benefits that you normally couldn’t get out of an economic activity.

Once the crisis seemed inevitable, we started to ask ourselves if regulators were relying on a "free market philosophy" justifying their ‘just-let-things-go-strategy’?

All this risk-taking by banks and firms added up to a big gamble for the worldwide financial system, which only became fully apparent as the crisis unfolded. Because no firm knew of other firms' exposures to complex and risk full derivatives, it was difficult to predict how problems would flow through the system. The lack of transparency, that’s what it’s all about.

It’s clear that regulators didn't regulate. This counts as well for the Federal Reserve (U.S.) as for the revisors in mortgage-banks, investment banks and other banks. Whether they didn’t see the upcoming disaster, or wether they voluntarily looked the other way, the regulators have always been largely involved.


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As the crisis approached, few in government spotted these problems. In Belgium, for instance, the government was busy trying to find a solution for the communautary problems, and they didn’t have ear to the financial problems that seamed small and not dangerous.

We can conclude that the combination of negligence, lack of transparency and wrong economic theory resulted in the current financial crisis. For years, the worldwide economic system has been based on the illusion of "It doesn't matter." First there was the illusion of "Deficits don't matter”. Later the illusion of "it doesn't matter" got extended to money creation, megalomanias credit expansion, the stock-market bubble and the housing boom.

Then more problems appeared, first with some banks and than, after “the Lehman brothers-effect”, with a lot of banks. The spread in inter-bank lending skyrocketed and only improved after massive state intervention. The globalisation of the banking-system led to economic weakness spreading around the globe. There is no new economic growth in sight. Yet many investors stay put because they have been conditioned to believe that government will bail them out, as we have seen with the nationalisation of Fannie and Freddie for the U.S and with Fortis, KBC and Dexia for Belgium.

In the next chapter I will give an overview of the most important events.


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III. A time line of the most important events.

Hasty takeovers, government bailouts, bankruptcy filings, CEO ousters and lots of interest rate cuts. 29 Together, they've provided plenty of controversy and second-guessing during the year-long financial crisis. These are the most important events causing the current financial crisis.

August 10, 2007: Fed Sounds Alarm

Amid growing financial market turbulence and cries for an interest rate cut, the Fed says it is "providing liquidity to facilitate the orderly functioning of financial markets." A week later, the Fed sayd "conditions have deteriorated" and it "is prepared to act as needed, but doesn't cut rates.

Oct. 30, 2007: CEO Casualties Begin

Merrill Lynch Chairman and CEO Stanley O'Neal is forced out, following major losses and write downs because of its subprime business.

The disclosure of a massive loss linked directly to his strategy of taking more risk in the bond markets, resulted in a write down of $8.4 billion of bad bonds and other securities, and caused O'Neal to lose the confidence of the Merrill Lynch board, which he had largely composed since he became CEO in 2002.

His successor, Kenneth D. Lewis (chief executive officer and president of Bank of America) had the difficult task to avoid a civil war inside the company by selecting a candidate that could bring the various warring factions together and help Merrill survive as an independent firm.

His biggest mistake was to ramp up the firm’s risk taking. He raised Merrill’s exposure to credit market risk instead of letting the firm grow through major acquisitions or organically. Merrill began trading more in riskfull credit market instruments, like collateralized debt obligations and he even bought a subprime mortgage lender at the height of the market.

When the markets for mortgage-backed securities plummeted, Merrill was among the hardest hit—and, maybe the hardest hit of all the Wall Street firms. It initially announced a write down of $5 billion due to losses from these bonds. But afterwards they wrote down a total of $8.4 billion, and despite O’Neal’s claim that he used a conservative analysis to come up with the write down, many analysts said the firm would likely have to announce additional losses in the fourth quarter.

March 16, 2008: Bear Stearns Bought

The brokerage firm Bear Stearns is bought by JPMorgan Chase in a $2-a-share deal engineered and backed up by the federal government in the wake of big losses in the mortgage-backed securities market and a shrivelling stock price. The price is later adjusted to $10 a share, which hit a record high of about $171 in January 2007.


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The takeover underlined the risks banks and financial companies were facing as the U.S. mortgage crisis deepend. Minutes after the deal was announced, the U.S. central bank made an emergency interest rate cut and opened direct lending to Wall Street, but the moves failed to soothe panicked investors. A bit later, the U.S. dollar fell to a new record low against the Euro.

Bear Stearns had about $16 billion exposure to commercial mortgage backed securities assets and $15 billion exposure to prime, Alt-A mortgages (mortgages given to people with relatively high credit scores who can't document their income) and $2 billion exposure to subprime. The buyer, JPMorgan, which in 2007 reported income of $15.4 billion, had a relatively small prime brokerage business.

July 11, 2008: Indy Mac Bank Fails

Federal regulators seize the thrift amid concern about a run on deposits, as the combination of the credit crunch and mortgage meltdown suffocates its business. The failure will cost the Federal Deposit Insurance Fund an estimated $4-8 billion.

Sept. 7, 2008: Fannie, Freddie Seized

The federal government took control of Fannie Mae and Freddie Mac, the two publicly-traded, government-sponsored financial giants that held or guaranteed about half the nation's $12 trillion in mortgage loans. This mortgage debt was sapping the company’s vitality and threatened to undermine them at a time other sources of housing finance had largely run dry. As already mentioned in chapter two, as house prices, earnings and capital continued to deteriorate, the ability of Fannie Mae and Freddie

Mac to fulfil their mission deteriorated. They had been unable to provide needed stability to the market. Note that the buyout of two institutions, Fannie Mae and Freddie Mac was critical to turning the corner on housing. Freddie Mac chief executive Richard Syron and Fannie Mae's CEO, Daniel Mudd, were ousted and replaced by David Moffett, a former top official at US Bancorp and Herb Allison, formerly with Merrill Lynch. In the next chapter, I will comment a bit more the Fannie and Freddie case.

This was the biggest federal bailout ever, in a bid to support the U.S. housing market and ward off more global financial market turbulence.

Sept. 10-15 2008: Lehman Brothers Flounders

The Wall Street firm Lehman Brothers puts itself up for sale after reporting a $4 billion loss, but failed to close a deal. Days later, with the federal government having passed on a bailout, Lehman files for chapter


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11 bankruptcy protection, the biggest in history. 1 This event led to one of the largest confidence crises in the financial sector in the last century: the failing of a large bank was thought to be impossible, thought inspired by the salvage of Bear Stearns (cf. supra). This event caused a massive increase in spreads on interbank lending.

Sept. 15, 2008: Merrill Lynch Bought

Merrill Lynch agrees to be bought by Bank of America in a $50-billion, all-stock transaction. The acquisition makes Bank of America the largest brokerage in the world, with more than 20,000 advisers and $2.5 trillion in client assets. Merrill stuck with some of the same toxic debt which torpedoed Lehman's balance sheet, has been hit hard by the credit crisis and has written down more than $40 billion over the last year.

For some economists, it was a surprising step because earlier that month, Merrill Lynch arranged to sell over $30 billion in repackaged debt securities to the Dallas-based private equity firm Lone Star Funds. They seemed to improve their business and to progress.

The Bank of America bought about $44 billion of Merrill's common shares, as well as $6 billion of options, convertibles, and restricted stock units.

Sept. 16, 2008: AIG Bailed Out

The federal government provides an $85-billion emergency loan package under which it takes a majority stake in American International Group. The move comes amid a cash crunch, triggered by $18 billion of losses over three quarters, a sinking stock price and debt downgrades.

1 Chapter 11 is a chapter of the United States Bankruptcy Code, which permits reorganization under the bankruptcy laws of the United States. Chapter 11 bankruptcy is available to any business, whether organized as a corporation or sole proprietorship, and to individuals, although it is most prominently used by corporate entities.


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IV. Fannie and Freddie 3 Fannie and Freddie fuelled Wall Street's efforts to securitize subprime loans by becoming the primary customer of all AAA-rated subprime-mortgage pools. In addition to this, they held an enormous portfolio of mortgages themselves.

Over the years, Fannie and Freddie added up these mortgages to an enormous obligation. As of 2008 June, Fannie alone guaranteed more than $388 billion in high-risk mortgages! This created an environment within which even mortgage-backed securities assembled by others could find home.

The mortgages in play were only low-risk investments if real estate prices continued to rise, which they were supposed to do. But, as the real estate market had already risen sharply over the last years and trees don’t grow into the sky, real estate prices started to fall. Given the excessive debt of many lenders and an overleveraged credit market, the whole system came down like a house of cards.

The two government-sponsored mortgage giants have long maintained they were merely victims of a financial act they didn’t control. As lots of other mortgage-banks, they were blindsided by the greedy excesses of the subprime lenders who lacked scruples. But there is no doubt that Fannie and Freddie are partially responsible for the mortgage-crisis. They have played an important role in the financial crisis. In 2004, when the companies saw their market share eroded by products as Adjustable Rate Mortgage (ARM’s) and interest-only mortgages, they walked further out on the risk curve to maintain their market position. Out of their reformed policies and management resulted that the two companies were responsible for some $1,6 trillion worth of subprime credit!

The clear gravity of the situation pushed the legislation forward. Some might say the current crisis couldn't be foreseen, though yet in 2005 Alan Greenspan told Congress how urgent it was for it to act:” If Fannie and Freddie continue to grow, continue to have the low capital that they have, continue to engage in the dynamic hedging of their portfolios, which they need to do for interest rate risk aversion, they potentially create ever-growing potential systemic risk down the road,'' he said. ``We are placing the total financial system of the future at a substantial risk.''3

What happened next was extraordinary. For the first time in history, a serious Fannie and Freddie reform bill was passed by the Senate Banking Committee. The GSE (government sponsored enterprises)-bill gave the regulator power to crack down, and would have required the companies to eliminate their investments in risky assets.

If that bill had become law, then the world today would be different. In 2005, 2006 and 2007, “a blizzard of terrible mortgage paper fluttered out of the Fannie and Freddie clouds”, burying many of our oldest and most venerable institutions. Without their check books keeping the market liquid and buying up excess supply, the market would probably not have existed.


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The bill didn't become law because Democrats opposed it on a party-line vote in the committee, signalling that this would be a partisan issue. Republicans couldn't even get the Senate to vote on the matter.

With the necessary hindsight, the roadblock built by Senate Democrats in 2005 is unforgivable. Many who opposed the bill doubtlessly did so for honourable reasons. Fannie and Freddie provided mounds of materials defending their practices. Perhaps some found their propaganda convincing.

But we now know that many of the senators who protected Fannie and Freddie, including former senators Barack Obama and Hillary Clinton received mind-boggling levels of financial support from them over the years.

Throughout his political career, Obama has gotten more than $125,000 in campaign contributions from employees and political action committees of Fannie and Freddie.

Clinton, the 12th-ranked recipient of Fannie and Freddie PAC and employee contributions, has received more than $75,000 from the two enterprises and their employees.

So we must conclude that both Fannie and Freddie clearly understood that these mortgages were risky. Though, many homeowners didn’t understand them, didn’t see the risk and many corporations (mostly financials) were putting their business at risk by buying up Alt-A and subprime mortgage-backed securities.

Also remember that during the period when Fannie and Freddie increased their exposure to credit risk, their regulator made no visible effort to enforce any limits. As shown above, the two mortgage-giants tried to buy everybody in town from both political parties, and the companies did it well enough to make themselves immune from regulatory scrutiny.

Take a look at annex 2 to learn more about loans and mortgages.

An Alt-A loan is nor really a loan type. Alt-A is a way lenders have of grading or categorizing a loan. For many lenders, Alt-A would be synonymous with A-minus. A-minus has traditionally been used to designate borrowers whose credit scores are somewhat below those of A grade borrowers. The traditional definition of Alt-A has been loans that have less than full documentation, also referred to as low doc/no doc loans.

What does all of the mean to the borrower? It is important for the borrower to understand that they and the loan they are applying for has a grade. The best place to be is A. A means the the borrower's credit score is very good and the deal is straight forward without anything out of the ordinary. A loans get the most advantageous interest rates and terms.

Note that every lenders criteria for Alt-A/A-Minus may be vary. Credit score requirements will be the most common area of variance. It tends to boil down to the risk tolerance of the lender.

Source: www.citytowninfo.com


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V. The current financial crisis’ nature

The current financial crisis is not of a cyclical nature. The term economic cycle refers to the fluctuations of economic activity around a long-term growth trend. It is a period of macroeconomic expansion followed by a period of contraction. The cycle involves shifts over time between periods of relatively rapid growth of output, and periods of relative stagnation or decline. The current financial turmoil is the symptom of structural imbalances in the real economy. Over decades, expansive monetary policy has gone hand in hand with implicit and explicit bailout guarantees, and this has fundamentally distorted the process of capital allocation.

The present financial crisis can also been seen as a confidence-crisis. Banks were taking huge bets with each other over loans and assets. Complex products were designed to move risk and disguise the sliding value of assets. Financial markets hinge on trust and that trust has been eroded. The current financial crisis reflects that many debtors have reached their debt limit and that creditors are lowering that limit. From now on, business and consumers, governments and investors must work under the restraints of lowered debt ceilings. The collapse of different banks marks a low in confidence. Financial companies have become overextended and are now in need of deleveraging. America's financial system failed in its responsibility to manage risk and to allocate capital. Regrettably, toxic mortgages and the practices that led to them were exported to the rest of the world, especially Western Europe.

Economic policy as it is currently practiced is in a fix: lower interest rates may temporarily help to alleviate the financial crisis, but they exacerbate the fundamentals that are the cause of the financial crisis. Equally, a lower dollar would make imports costlier for the United States, while a strong dollar comes with lower import prices. On the other hand, while a low dollar would help to expand exports, a strong dollar impedes export growth.

Without an adaptation that would increase savings, decrease consumption, decrease credits and reduce imports, the US economy can only go on in the old fashion with ever more debt accumulation. Knowing that the US is at the origin of the crisis and that the US is still a world player, we can expect Europe to follow. The financial crisis has reduced the willingness or possibility of creditors to extend loans. It has become very difficult to get a loan. A profound restructuring of global capital has become unavoidable. Such a process is quite different from a recession in the traditional sense. Getting ouf of a traditional cyclical crisis can be done by using macroeconomic instruments as fiscal and monetary policies. These fiscal and monetary policies aren’t effective enough when it comes to re-establishing a balanced capital/financial structure. Rebalancing the distorted financial structure requires stronger regulation and important change in regulatory structures.

In chapter eight Iwill highlight some possible measures to get out of this crisis.


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VI. The great depression & lessons from the past

A big question is if we were able to foresee this crisis. During the past centuries the world has been hit by different other financial crises. Was this crisis avoidable? In this chapter I will give a small overview on the most important crises of the past. We will go through the Barings-crisis of 1890, the great depression of the thirties (after the crash of 1929), the US savings and loan scandal, the stock market crash of 1987, the Long Term Capital Management downfall, to end up with the DOT.COM crash of 2000

28OVEREND & GURNEY, 1866; BARINGS, 1890

The failure of Overend&Gurney, a London bank in 1866 led to a key change in the role of central banks in managing financial crises.

Overend&Gurney was a discount bank which provided money for commercial and retail banks in London. When it declared bankruptcy in May 1866, many smaller banks were unable to get funding and went under. As a result, reformers like Walter Bagehot advocated a new role for the Bank of

England as the "lender of last resort" to provide liquidity to the financial system during crises, in order to prevent a bank failure or systemic failure.

This doctrine was next implemented in the Barings Crisis in 1890, when losses by the Barings Bank - made on its investments in Argentina- were covered by the Bank of England to prevent a systemic collapse of the UK banking system. Secret negotiations between Barings and London financiers led to the creation of an £18m rescue fund in November 1890, before the extent of Barings' losses became publicly known.

THE CRASH OF 1929

The Wall Street crash of 1929, also known as Black Thursday, was an event that sent both the US and the global economy into a tailspin, contributing to the Great Depression of the 1930s.

After a huge speculation in the 1920s, based partly on the rise of new industries such as radio broadcasting and car making, shares fell by 13% on Thursday, 24 October. Despite efforts by


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the stock market authorities to stabilise the market, stocks fell by another 11% the following Tuesday, 29 October. By the time the market had reached bottom in 1932, 90% had been wiped off the value of shares. Afterwards, it took 25 years before the Dow Jones Industrial Average index recovered to its 1929 level.

The effect on the real economy was severe; the widespread share ownership meant that the losses were felt by many middle-class consumers. These consumers cut their purchases of big consumer goods such as cars and homes, while businesses postponed investment and closed factories. This provoked an economic slow-down that engendered massive unemployment.

In 1933, Franklin D. Roosevelt launched The New Deal. The US central bank actually raised interest rates to protect the value of the dollar and preserve the gold standard, while the US government raised tariffs and ran a budget surplus. New Deal measures alleviated some of the worst problems of the Depression, but the US economy did not fully recover until World War II, when massive military spending eliminated unemployment and boosted growth.

The New Deal also introduced extensive regulation of financial markets and the banking system through the creation of the Securities and Exchange Commission (SEC) and the Federal Deposit Insurance Corporation (FDIC), and the separation of commercial and retail banking through the Glass-Steagall Act.

Should we compare the current financial crisis with the crisis 1930? We now have the monetary and fiscal instruments and understanding to avoid a collapse on that scale. The crash of 1929 gave us organisations such as the SEC and the FDIC. One of the causes of this financial crisis is massive speculation, a cause that we will also find back in the crisis of 1929. We do also see that some consequences are similar: widespread share-ownership makes that almost everyone is touched by the bank-crisis, consumers cut their important purchases, industry goes down, investment decreases, factories are closed, unemployment increases. We are following a similar down-ward spiral.

US SAVINGS AND LOAN SCANDAL, 1985

US Savings and Loans institutions were local banks that made home loans and took deposits from retail investors, similar to building societies in the UK and the “spaarkassen” or “caisses d’épargne” in Belgium. The 1980s were dominated by financial deregulation. In consequence, banks were allowed to engage in more complex financial transactions.

By 1985, many of these institutions were all but bankrupt. The US government insured many of the individual deposits in these institutions, and therefore had a big financial liability when they collapsed. The government took over and sold any S&L assets it could, including repossessed homes, taking over the bankrupt institutions.

The cost of the bail-out eventually totalled about $150bn. However, the crisis probably strengthened the bigger banks by weeding out their weaker rivals, and laid the groundwork for the wave of mergers and consolidations in the retail banking sector in the 1990s.

Could the knowledge ported by this crisis have had helped us avoiding the current crisis? Not really, the current crisis is more complex. But we see that the 1980s already warned about the consequences of a low degree of regulation.


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THE CRASH OF 1987

US stock markets suffered their largest one-day fall on 19 October 1987, when the Dow Jones Industrial Average index dropped 22% followed by drops on the European and Japanese markets.

The losses were triggered by the widespread belief that insider trading and company takeovers on borrowed money were dominating the markets, while the US economy was entering into an economic slowdown. There were also worries about the value of the US dollar, which had been declining on international markets. Concerns that major banks might go bust led the Fed and other major central banks to lower interest rates sharply.

"Circuit-breakers" were also introduced to limit program trading and allow the authorities to suspend all trades for short periods. Circuit-breakers are measures instituted by exchanges to stop trading temporarily when the market has fallen by a certain percentage in a specified period. They are intended to prevent a market free fall by permitting buy and sell orders to rebalance.

The crash seemed to have little direct economic effect and stock markets soon recovered; it was a minor stock-market crash. But the lower interest rates, especially in the UK, may have contributed to the housing market bubble of 1988-89 and to the pressures on the pound sterling which led to the devaluation of 1992.

This crash already showed that global stock markets are closely linked, and changes in economic policy in one country could affect markets around the world. Laws on insider trading were tightened up in the US and UK and later on, other European countries also instored laws on insider trading.

LONG-TERM CAPITAL MANAGEMENT, 1998

Long-Term Capital Management was the management arm of a hedge fund that operated from its founding in 1993 until its liquidation in early 2000. It went through a period of spectacular success from 1994 to early 1998. The belief was that in the long run, the interest rates on different government bonds would converge, and the hedge fund traded on the small differences in the rates.

The collapse of the hedge fund Long-Term Capital Market occurred during the final stage of the world financial crisis that began in Asia in 1997 and spread to Russia and Brazil in 1998. In August of 1998 Russia defaulted on its debt and the financial markets came unriddled.

LTCM, which had borrowed a lot of money from other companies, stood to lose billions of dollars while investors fled from other government paper to the safe haven of US Treasury bonds, and interest rate differences between bonds increased sharply. In order to liquidate its positions it would have to sell Treasury bonds, plunging the US credit markets into turmoil and forcing up interest rates.

The Fed decided that a rescue was needed. It called together the leading US banks, many of whom had invested in LTCM, and persuaded them to put in $3.65bn to save the firm from imminent collapse. The Fed itself made an emergency rate cut in October 1998 and markets soon returned to stability. LTCM itself was liquidated in 2000.


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The LTCM failure highlighted the possibility that problems at one financial institution could be transmitted to other institutions, and potentially poses risks to the financial system. This is what we see today. Problems do not stay centerred, almost everyone is exposed to the risks brought by massive lending, extreme hedging,... Although LTCM was a hedge fund, this issue can not be limited to hedge funds. Other financial institutions, including banks and securities firms are highly leveraged too. While leverage can play a positive role in our financial system, problems can arise when financial institutions go too far in extending credit to their customers and counterparties. The failure of LTCM illustrated the need for all participants in our financial system to face constraints on the amount of leverage they assume. It should have been a good lesson, but we did not learn our lesson! Our financial system still relies on highly leveraged institutions.

In the case of LTCM, its investors, creditors, and counterparties did not provide an effective check on its overall activities. This check on overall activities is important to guarantee the system’s stability, but a high degree of leverage made it almost impossible to check on the details of every activity. LTCM's use of leverage highlighted the lack of regulation in the over-the-counter market. There is a need for more transparency and stronger regulation. Note that the failure of LTCM does not necessarily mean that any use of leverage is bad, but it highlights the potential negative consequences massive leverage can have. LTCM failed to manage multiple aspects of risk internally. Managers mostly focused on theoretical models and not enough on liquidity risk, gap risk, and stress-testing. With such large positions, LTCM should have focused more on liquidity risk. LTCM's model's underestimated the probability of a market crisis and potential for a flight to liquidity. The LTCM-crisis further marks the importance of an effective Risk Management, because exposure to specific risks can cause dramatic damage.

THE DOT.COM CRASH, 2000

During the late 1990s, stock markets became beguiled by the rise of internet companies such as Amazon and AOL, which seemed to be ushering in a new era for the economy. Their shares soared when they listed on the Nasdaq stock market.

The boom peaked when internet service provider AOL bought traditional media company Time Warner for nearly $200bn in January 2000. But in March 2000, the bubble burst, and the technology-weighted Nasdaq index fell by 78% by October 2002!

The crash had wide repercussions, with business investment falling and the US economy slowing in the following year, a process exacerbated by the 9/11 attacks, which led to the temporary closure of the financial markets. The Federal Reserve cut interest rates throughout 2001, gradually lowering rates from 6.25% to 1% to stimulate economic growth.

After having given this overview on the most important crises in the past, we remind some key lessons:

Globalisation has increased the frequency and spread of financial crises, but not necessarily their severity.

Early intervention by central banks is more effective in limiting their spread than later moves.


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It is difficult to tell during the first phases of the crisis, whether a financial crisis will have broader economic consequences.

Regulators often cannot keep up with the pace of financial innovation: a permissive policy by the financial authorities concerning complex financial products has frequently led to acceleration or even creation of crises.

More transparency and better risk-management is needed.

Could we have anticipated this crisis?

As seen above, since 1980, we have had about five or six crises, the US Savings and Loans Scandal, the crash of 1987 and the failure of Long-Term Capital Management in 1998, to name only three. So the regulators and the markets have precedents from which they could have learned. If we take in count the 5 key lessons defined above, we can conclude this crisis could partially have been anticipated.

We have a certain idea of market fundamentalism, which is that markets are self-correcting. I think that this is a false idea because it is generally the intervention of the authorities that saves the markets when they get into trouble. As we’ve seen over the past few months, each time, it is the authorities that bail out the market, or organize companies to do so.

Maybe this crisis could have been avoidded if people had understood what was wrong with the current system. But finally, who could have recognized that?

The bankers? The authorities? The regulators? Well, the Federal Reserve and the Treasury failed to see what was happening. Fed governor, Edward Gramlich, warned of a coming crisis in subprime mortgages in his book published in 2007, but to no avail. It is clear that the authorities did not want to see it coming. So it looks like as if it came as a surprise.

How much worse will it get? The situation is definitely much worse than is currently recognized. You have had a general disruption of the financial markets, much more pervasive than any we have had so far. This may not seem very optimistic, but in crisis times it is pessimism that rules. During crises, we frequently forget Popper’s quote: “optimism is a moral duty.”


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Global Foreign Direct Investment (as % of GDP)

-2%

0%

2%

4%

6%

8%

10%

12%

1990 1992 1994 1996 1998 2000 2002 2004 2006ource: IFS - IMF.

VII. The Impact on Emerging Countries. Throughout this crisis that has consumed the attention of the world last year, we have watched with grave concern as it cascaded outwards from the sectors originally affected, that are the housing sector and the mortgage market. I think we can easily define this crisis by using Alan Greenspan’s words: “a once-in-a-century credit tsunami”. Instability has surged from sector to sector, first from housing into banking and other financial markets, and then on into all parts of the world economy. The crisis has surged across the public-private boundary, as the hit to private firms’ balance sheets has now imposed heavy new demands on the public sector’s finances. A good example – as seen before- is Fannie and Freddie. But this crisis has also surged across national borders within the developed world... That’s one of the biggest reasons to fear that the crisis will swamp emerging markets and other developing countries, cutting into their economic progress of recent years. 20

The investment-led boom in the developing world.

In the chart we can see the bank’s exposure to emerging markets (in %of the countries GDP). This chart shows how emerging markets depend on the banks and the countries where these banks are settled. During the period from 2002 to 2007, developing economies have been thriving. One important set of reasons was domestic. From a macro economical view, we can say that the developing economies had entered the decade in much better shape than they had the previous two decades, for example with lower inflation and more sustainable fiscal situations. These conditions predisposed the developing world to more rapid growth. But because of the developed-country boom, the developing world found its growth stoked further by increased export revenues and higher commodity prices and a surge in foreign direct investment. We know that, during this period, economic growth increased export demand, so that developing country exports accelerated even beyond their rapid growth pace of the 1990’s. The increase of commodity prices resulted from and contributed to the growth in many developing countries. Exports increased as a share of developing countries’ GDP from 29 percent in 2000 to 39 percent in 2007. Another problem is that a severe and prolonged recession could increase risk aversion, hurting investment flows to emerging markets.


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Czech Republic

1%

2%

3%

4%

5%

6%

7%

8%

Jan-06 M ay-06 Oct-06 M ar-07 Aug-07 Jan-08

Inflation Policy rate

Chile

1%

2%

3%

4%

5%

6%

7%

8%

9%



China

%

1%

2%

3%

4%

5%

6%7%

8%

9%



Colombia

3%

4%

5%

6%

7%

8%

9%

10%



South Africa

3%

4%

5%

6%

7%

8%

9%

10%

11%

12%



South Korea

1%

2%

3%

4%

5%

6%



The rapid increase in net private capital flows, direct and portfolio equity flows and remittances of the country’s workers led to an investment boom in many developing countries, led by the BRIC-countries (Brazil, Russia, India, and China). This in turn stimulated their demand for capital goods from the US, Japan, and other developed economies5, further fuelling the growth of their economies. As a result the developing world as a whole achieved its highest growth rates in decades.

This chart shows the evolution of the private capital flow to emerging countries from 1997 to 2007. We can see the private capital flow sharply declined after the dot-com bubble of 2000. We can accept a much larger dip in the current crisis, knowing that the current crisis is one from another gauge.

A most important current feature of many emerging markets is their ability to tighten monetary policy -increase interest rates- in the presence of inflationary pressures. This contrasts with monetary policy in industrialized countries where fears of a significant slowdown in economic growth are keeping interest rates low and decreasing…in spite of expectations of higher inflation.


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Now, after that dynamism collapsed in developed countries, what will be the effect on emerging markets and poorer countries?

Severe and protracted recession in the US / Banking crisis, high commodity prices and a high inflation leading to increases in industrial countries’ interest rates are some factors that will have a great influence on emerging countries. I think we are living the worst scenario: a decline in the value of banks’ assets, loss of bank capital, credit crunch financing problems in corporations and non-bank financial institutions, recession, increase in severity of bad banks’ assets, bank-bailouts...

Foreign direct investment tends to decline sharply during global slowdowns. Trade flows will also be affected, especially because the US financial troubles expand to other industrial countries, particularly Europe. Export growth suffers the most in periods of global slowdowns.

The sustainability of high commodity prices is less risky in the short and medium-term due to two factors that are of a cyclical nature or of a more structural nature. For the cyclical nature, we can say that this is caused by an inverse correlation between the value of the dollar (and to a lesser extent the euro) and the price of commodities. This is because commodities -especially oil, gold and food- are perceived as a hedge against currency weakness and the risk of inflation

The structural factors concern the influence China has on the global system. E.g. the recent policy signals by the Chinese authorities to control inflation point towards further increases in interest rates in China and further appreciation of the RMB against the US dollar. We have to take into account that China, a major importer of many commodities, will continue a strong path of growth in the coming years. This will not be an inconspicuous movement. During Januar and Februar 2009, Chinese GDP growth decreased, and so, China had to take measures to keep it’s growth above the 8%. Note that this is the minimum-percentage to keep the growth of employment high enough to support the migration to the cities.

Another good example of a structural factor is -as everyone knows- the supply problems in the precious and industrial metals, which are a long-term issue, especially given South Africa’s power crisis. Note that South Africa produces 69% of platinum, 30% of palladium and 18% of world’s supply of gold. Other structural factors are land and water constraints

Aluminum prices: Spots and Futures

1200

1400

1600

1800

2000

2200

2400

2600

2800

3000

2002 2003 2004 2005 2006 2007 2008 2009 2010

USD

per

met

ric to

n

Source: IFS-IMF and LME

Futures

Gold prices: Spots and Futures

200

400

600

800

1000

1200

2002 2003 2004 2005 2006 2007 2008 2009 2010

USD

per

troy

oun

ce

Source: IFS-IMF and NYMEX

Futures


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supporting high prices for agricultural commodities. On the following graphic, we can clearly see that commodity prices almost crashed during the last months of 2008. This graphic shows us the Reuters/Jefferies CRB Index; which is one of the most often cited indicators of overall commodity prices. The CRB is representative of a broad range of commodity prices, that offers investors a broad and reliable benchmark for the performance of the commodity sector.

Very low commodity prices, a decline in finance opportunities ... all affect the economy of the exporting countries. The most important effect is a substantial reduction in their exports. Remember that the IMF recently projected growth in world trade volumes of just 4.1 percent in 2009, down from 9.3 percent as 2006. On the 10th March of 2009, the head of the International Monetary Fund, Dominique Strauss-Kahn, said the following: “ the world economy is likely to shrink this year, in what some are referring to as the Great Recession.” He also said that sharp declines in world trade were likely to hurt African economies. While the fall in export volume growth is projected to be greater for advanced economies than for developing economies, the latter may also suffer more from declines in the terms of trade – especially in the case of commodity exporters. The IMF expects that developing countries’ collective GDP growth will decline to less than 5 percent, compared with an average of more than 7 percent over the period 2004-07. Moreover, the effects on developing countries may not be limited to a drop in investment and export earnings and a slowdown of GDP growth. There is the danger that emerging markets could go through crises of their own, for example if their own domestic asset-market bubbles


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burst and weaken their own banking sectors. Sharp drops in stock markets in developing countries have already warned us for this scenario’s possibility. Developing countries will need advantages –as the strengthening of macroeconomic policies including fiscal and external positions, the move to flexible exchange rate arrangement, a drop in inflation and reduced commodity prices –to limit the damage from this crisis. We conclude that developing countries are facing dilemmas whose solution will be highly dependent on how they behaved during the boom period, as well as how the global shock will affect their individual economies. Their ability to respond to the crisis will depend on whether emerging markets have room to act in a “anticyclical” way by increasing domestic demand without sacrificing excessively their fundamentals, such as the countries’ fiscal positions, debt levels, domestic inflation rates, and the health of their domestic banking sector.


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VIII. How to solve this problem? Is there a stimulus key to recovery? We will not be able to solve all the problems by using one single measure. A preliminary note is that no model of restructuring will be appropriate for every country or every bank. Where solutions need to be customized this should be done within a common strategy (on a regional or even worldwide scale) and framework that ensures transparency and a “level playing field”. In the medium-term, the initiatives already underway to improve the regulatory and supervisory frameworks will be crucial to build a resilient and innovative financial system. So one must remember that there is no "one-size-fits-all" policy mix because some countries have more fiscal and monetary space than others. Considering this, it is welcome that some emerging economies now have more space for policy easing than in previous crises and are making use of it. There are three domains in which we have to invest in order to get the world back on track, these are:

1. The action already taken by many governments to stabilize financial markets and get credit flowing again and/or fiscal stimulus through a combination of increased government spending and tax cuts to revive consumer demand. A number of governments around the world have already announced or accomplished stimulus plans, including in the United States, Japan, Europe, China, and India. The importance of doing more on the spending side is that the reaction of the economy to more spending is quicker than the reaction to a decrease in taxes. But not only countries have to do an effort. Worldwide financing organizations are doing extra efforts, the IMF, for example has already committed $47.9 billion in lending to a number of economies affected by the crisis.

Monetary and fiscal policies need to become even more supportive of aggregate demand and sustain this stance over the foreseeable future, while developing strategies to ensure long-term fiscal sustainability. Moreover, international cooperation will be critical in designing and implementing these policies in order to avoid destabilizing distortions.

2. Liquidity support for emerging market countries to reduce the adverse effects of the widespread capital outflows triggered by the financial crisis. The continuation of the financial crisis, with government policies failing to dispel uncertainty, has caused asset values to fall sharply across advanced and emerging economies, decreasing household wealth, and thereby putting downward pressure on consumer demand. We can expect real activity to contract by around 1½ percent in the United States, 2 percent in the euro area, and 2½ percent in Japan. Though more resilient than in previous global downturns, emerging and developing economies will also suffer serious setbacks.

3. Help for low-income countries harmed by fallout from the crisis and the lingering impact of last year's spike in food and fuel prices.

On the next page, you will see the latest IMF projections, an outlook on the changes in world economy. The crisis in financial markets has resulted in a global recession that continues to worsen. We see that the IMF prospects for global growth have markedly dimmed and prospects on international trade have slowed sharply.


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To conclude, I emphasize two types of measures that are needed to turn things around:

1. Stronger policy actions to restore financial sector health.

Reviving the functioning of the financial sector and unclogging credit markets is a necessary condition for economic recovery. The building blocks of what needs to be done have been assembled to varying degrees in many countries, but a comprehensive framework for restoring financial health and dealing with bad assets remains to be built. There is for instance the idea of creating a Bad Bank. More aggressive and concerted actions are now needed—through a unified approach involving liquidity provision, capital injections, and disposal of problem assets.

2. Macroeconomic stimulus—both monetary and fiscal—to support demand.

On monetary policy, many central banks have taken strong actions to cut interest rates and improve credit provision. Lowering interest rates, as inflation pressures are subsiding, is a good measure. BUT: deflation is now a risk. In present circumstances, the effectiveness of low interest rates to support activity is likely to be constrained as long as financial conditions remain disrupted. Therefore, central banks will need to rely increasingly on unconventional measures to unlock key (high-spread, low-liquidity) credit markets.

On fiscal policy, many countries have announced and are already implementing sizeable stimulus. The key here is to design packages that provide maximum boost to demand, which argues for measures to increase spending. However, fiscal deficits are widening sharply because of the cyclical downturn and the impact of asset price declines on revenues, as well as stimulus measures and the cost of financial sector rescues. Policymakers need to strengthen fiscal frameworks and commit to credible longer-term policies that reverse the deficit build-up as economies recover.

In summary, an approach to nurse financial markets back to health should deal with the following topics:

• Central banks must provide ample liquidity to the financial system.

• Banks must be recapitalized to cover potential write downs.

• Problem assets on bank books must be dealt with in some manner.

• Speedy efforts to recapitalize banks and take care of distressed assets.

• A recognition that short-term policies must be consistent with the long-run vision for the financial system.

• Transparency about policies, the use of public financial support, and decisions about the future of any individual financial institution.

• A high level of international cooperation on national financial policies to support institutions to prevent competitive distortions, regulatory arbitrage that might harm other countries.


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So the measures that have already partially been executed by some governments and central banks need to be continued and –if necessary- stimulated. The only way to get out off this crisis is by using effective financial policies that are comprehensive and internationally coordinated. Some of the measures that have already been accomplished, have stabilized financial institutions, but there is always a certain risk that that they will distort credit allocation decisions, crowd out markets that do not receive special treatment, disfavour more efficient financial institutions that do not require public support. Moreover there are already concerns about the fiscal implications of the government guarantees and recapitalizations. The costs are likely to be higher than the amounts currently allocated, though much depends on the speed with which confidence is restored. A comprehensive and coordinated approach needs to be set up.


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IX. Executive Summary: The first clear sign that the US housing bubble was bursting, the mid-2007 crisis in the sub-prime mortgage market, transmitted losses to a whole set of securitized financial products such as mortgage-backed securities. Many of these new securitized financial products with layers of underlying assets were revealed to be far riskier than their credit ratings indicated. The drop in value of these assets dealt a blow to the balance sheets of many financial institutions. Even worse, the financial innovations of this decade – many of which had been sold on the promise that they would diversify and minimize risk – turned out to be transmission mechanisms for instability. The subprime mortgage crisis became a global financial crisis, which in turn has led to a further collapse in equity markets. Although the financial crisis struck first in the United States, the US is not alone in its vulnerability to shocks and collapses in consumer confidence. Many countries, both developed and emerging-market, have recently experienced bubbles in their asset markets. Financial globalization makes this crisis more complex than other crises in the past. Financial integration and cross-border holdings of mutual funds, hedge funds, developed-country bank subsidiaries, and insurance companies have transmitted turbulence and helped propagate asset price collapses in European and other countries. The bursting of a bubble this large, with the financial consequences that we have seen in recent months for credit and equity markets makes a recession inevitable in the US and likely in other developed economies. Indeed, job losses and recession already occurred on a large scale.


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X. Sources: 1. J.Korr, Explaining the Financial Crisis: Continuously Updated News Aggregation in

Action, September 17th, 2008. 2. M. Duffy, After the Financial Crisis, a Cleanup That Changes Everything, September

22nd, 2008. 3. K. Hassett How the Democrats Created the Financial Crisis, September 22, 2008,

www.bloomberg.com. 4. N. Roubini ,The Worst Financial Crisis Since the Great Depression is Getting Worse…and the Need for Radical Policy Solutions to the Crisis, Mar 19, 2008. 5.A. Mueller, What's Behind the Financial Market Crisis, 9/18/2008. 6. S.Schifferes, Financial crises: Lessons from history ,BBC News, 2008 7. Joseph Stiglitz, The fruit of hypocrisy, The Guardian, September 16th 2008 8. The Financial Crisis: An Interview with George Soros, the new york review of

books.Volume 55, Number 8 · May 15, 2008. 9. Mandel, How to Get Growth Back on Track business week, October 16th, 2008, 5:00PM

EST. 10.The Financial Crisis Blame Game News Analysis October 18th, 2008, 12:01AM EST. 11. www-personal.umich.edu/~alandear/glossary/f.html, October 18th, 2008. 12. "The foreclosure fight is on", Douglas County News-Press (06-20-2008), November

12th,2008. 13. Block Colorado Foreclosure Blog, www.blockcoloradoforeclosure.com. 14. M.Bartiromo, "Jitters On The Home Front", Business Week. March 17th 2008. 15. Economist - When Fortune Frowned, October 9th,2008. 16. Blackburn - Subprime Crisis November 12th, 2008. 17. Hyman Minsky: Why Is The Economist Suddenly Popular? Dailyreckoning.co.uk.

October 10th 2008 18.F. Shostak "Does the Current Financial Crisis Vindicate the Economics of Hyman

Minsky? October 19th,2008 19. http://www.statefarm.com/bank/loans/mortgage/mort_products.asp


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20. Justin Yifu Lin, The Impact of the Financial Crisison Developing Countries,Korea Development Institute, Seoul,October 31, 2008

21. Global Financial Stability Report, IMFth, , January 28th, 2009. 22. Http://www.imf.org/External/Pubs/FT/fmu/eng/2009/01/pdf/0109.pdf, January 29th 23. http://www.guardian.co.uk/business/gallery/2008/oct/28/marketturmoil-creditcrunch?picture=339067974 charts 24. http://lippard.blogspot.com/2008/10/financial-crisis-via-charts-and-graphs.html 25. http://www.statefarm.com/bank/sr_cen, February 2nd, 2009 26. http://online.wsj.com/public/page/news-financial-markets-stock.html, Febrary 3rd, 2009 27. http://online.wsj.com/public/page/wall-street-in-crisis.htmlter/morgloss.asp, February 4th, 2009 28. www.cnbc.com/id/26755842, January 29th 2009


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