A financial crisis is a situation when money demand quickly rises relative to money supply. Until a few decades ago, a financial crisis was equivalent to a banking crisis. Today it may also take the form of a currency crisis. Many economists have come up with theories on how a financial crisis develops and how it could be prevented. There is, however, no consensus and financial crises are still a regular phenomenon. A stock market crash is an example of a financial crisis
After the Great depression 1930, the worst financial crisis of the world is the crisis of US in 2008. Different researchers argue different causes of this crisis but mostly are common in point that this crisis occurs due to market's failure, regulatory failure and major contribution to the crisis is the failure of the political decisions or you can say that it's a political failure.
From 1970, there are at least 124 systematic financial crises (Laeven and Valencia 2008). A researcher Giles argued that (2008), 'there is no doubt that the credit crisis, which has morphed into recession across advanced economies, leaves most economic forecasters with ample egg on their face'.
The U.S. crisis has erased about US$25 trillion from the stock market which is definitely unexpected. The U.S. housing bubble burst in year 2007 which was at peak in 2005-06. High default rates on "sub prime" and adjustable rate mortgages (ARM), began to increase quickly thereafter. An increase in loan incentives such as easy initial terms and a long-term trend of rising housing prices had encouraged borrowers to assume difficult mortgages in the belief they would be able to quickly refinance at more favorable terms. However, once interest rates began to rise and housing prices started to drop moderately in 2006-2007 in many parts of the U.S., refinancing became more difficult.
In the US, sub-prime market mortgage lending, to households without the essential means to repay loans, took on huge proportions; according to Lin (2008) about US$1.3 trillion was lent in sub-prime mortgages. US mortgage lenders, most infamously the institutions known as Fanny Mae and Freddie Mac, securitized these sub-prime loans, which were then sold throughout the financial system as assets. They were able to issue and securitize these bad loans due to a combination of inadequate regulation and financial innovation. The latter made it difficult for other institutions to assess the risks of these securitized mortgages and led to increased sub-prime mortgages (Bicksler 2008).
By the summer of 2007 rising defaults on mortgages and growing numbers of foreclosures in the US signaled that the sub-prime market was in crisis. House prices and financial stock prices started to fall. This reduced the value of household wealth in the US by trillions. The solvency of Fanny Mae and Freddie Mac, as well as of a number of well-known international financial institutions was in danger by these defaults and the drops in house and stock prices. On 7 September 2008, the US government nationalized Fanny Mae and Freddie Mac. Then, on 15 September 2008, the firm of Lehman Brothers filed for bankruptcy; with US$639 billion in assets, it was the largest in the history of the US. This resulted in widespread financial panic, with large-scale selling of stocks. Central to the sudden decrease in accessibility of credit, particularly in the inter-bank market, which sudden the collapse of many firms, is what Taylor (2009: 12) describes as the 'Queen of Spades problem'.
What began as a bursting of the U.S. housing market bubble and a rise in foreclosures has ballooned into a global financial and economic crisis. Some of the largest and most venerable banks, investment houses, and insurance companies have either declared bankruptcy or have had to be rescued financially. In October 2008, credit flows froze, lender confidence dropped, and one after another the economies of countries around the world dipped toward recession. The crisis exposed fundamental weaknesses in financial systems worldwide, and despite coordinated easing of monetary policy by governments, trillions of dollars in intervention by central banks and governments, and large fiscal stimulus packages, the crisis seems far from over.
This financial crisis which began in industrialized countries quickly spread to emerging market and developing economies. Investors pulled capital from countries, even those with small levels of perceived risk, and caused values of stocks and domestic currencies to plunge. Also, slumping exports and commodity prices have added to the woes and pushed economies world wide either into recession or into a period of slower economic growth. The global crisis now seems to be played out on two levels. The first is among the industrialized nations of the world where most of the losses from sub-prime mortgage debt, excessive leveraging of investments and inadequate capital backing credit default swaps (insurance against defaults and bankruptcy) have occurred. The second level of the crisis is among emerging market and other economies who may be "innocent bystanders" to the crisis but who also may have less resilient economic systems that can often be whipsawed by actions in global markets.
Causes of the Financial Crisis
THE U.S. economy is currently experiencing its worst crisis since the Great Depression. The crisis started in the home mortgage market, especially the market for so-called "subprime" mortgages, and is now spreading beyond subprime to prime mortgages, commercial real estate, corporate junk bonds, and other forms of debt. Total losses of U.S. banks could reach as high as one-third of the total bank capital. The crisis has led to a sharp reduction in bank lending, which in turn is causing a severe recession in the U.S. economy.
Followings are the certain causes of the financial crisis of US
- Loose Macroeconomic Policies
- Transformation of Finance
- The Spread of Securitization
- Financial Crisis Ensues
- Regulatory Failure
Loose Macroeconomic Policies:
The current global financial crisis originated in the US partly because of loose monetary policy at the beginning of the decade. Loose monetary policy in the early 2000s compounded both domestic macroeconomic imbalances in the USA and global imbalances. The housing bubble led to many working class households shouldering large housing liabilities. At the same time, a calamitous drop in personal savings took place.
While personal savings as a percentage of disposable income was 9-10% during the 1970s and 1980s, it fell to around 2% in the early 2000s. By 2006-7, personal savings had collapsed to 0.4%. A savings ratio close to zero is historically unprecedented for a mature capitalist economy.
In 2007, the difference between aggregate domestic savings and investment in the US approached 5% of GDP. This gap corresponded to a ballooning US trade deficit, which exceeded US$ 700 billion during 2005-2007. The USA economy was on the edge of major financial instability even before its housing market imploded.
Meanwhile, the USA government ran large fiscal deficits in the early 2000s. These were heavily dependent on the purchase of US government securities by countries with substantial current account surpluses. In order to protect themselves against sudden capital outflowswhich were common during the financial crises of the late 1990smany developing countries had begun to build large precautionary stocks of international reserves.
This trend was most pronounced in developing Asia, whose aggregate current-account surplus had risen to almost 7% of GDP in 2007. China alone held international reserves worth more than US$ one trillion at the end of 2007. The great bulk of such reserves were held in US government securities. Despite low rates of return, developing countries continued to funnel their excess savings into the US economy, where they were important to sustaining the US bubble even after the Fed began to raise interest rates.
Transformation of Finance:
In addition to macroeconomic imbalances, the global crisis arose because of profound transformations in the financial system.
A major trend, clearly seen in the USA, is the extraction of financial profit by commercial banks directly out of personal incomes.
Growing individual dependence on private finance is apparent in housing, including subprime mortgages, but it can also be seen in education, health, pensions and insurance. This new practice of 'financial expropriation', i.e., the systematic extraction of financial profits out of wages and salaries, is one of the root causes of the current crisis (see Lapavitsas 2009).
Why were commercial banks motivated to generate financial profits from such new sources? The groundwork was laid by financial deregulation, which began in the late 1960s. Once deregulation took hold, commercial banks lost the captive liabilities (primarily deposits) that had previously sustained their activities.
Equally important is that large corporations have become less reliant on bank financing. They have financed their fixed investment either through retained earnings or direct borrowing in open markets. Hence, commercial banks have had to search for new profit-making opportunities. A decisive response was to turn to consumer and real-estate loans. In the US, the share of such loans in total bank lending rose from around 30% in the 1960s to almost 50% in the mid-2000s .
Lending to individuals can often be predatory, an aspect that took extreme forms in the course of the recent bubble. Mortgage lending rose dramatically in the US during 2001-2003, and then dipped, but remained at a very high level. As demand for ordinary mortgages began to slow after 2003, lenders increasingly offered subprime mortgages.
During 2004-2006, such mortgages totalled US$ 1.75 trillion, or almost one fifth of all new mortgages. They were marketed to the poorer segments of the US working class, many of the borrowers being Black or Latino household
The Spread of Securitization
Another major trend in the transformation of finance was the adoption by commercial banks of the practices of investment banking. Banks began to seek profits by operating in open financial markets, or through proprietary trading. Financial engineering and the rise of derivatives trading have been associated with the turn of commercial banks toward such financial practices.
The combination of the two major trends that we have highlighted, namely, drawing profits from personal incomes and resorting to investment banking, led to the huge financial bubble of 2001-2007.
The housing collapse in the USA would not have precipitated a global crisis had commercial banks not adopted investment banking techniques. This took the form of widespread securitization of mortgage loans. Simply defined, securitization meant parceling subprime mortgages into small amounts, packaging them with large composites of assets and selling the lots as new securities.
During 2004-2006, almost 80% of all subprime mortgages were securitized. As a result, subprime-mortgage-backed securities ended up in the portfolios of major financial institutions throughout the world. When US subprime mortgage holders began to default in large numbers in 2007, the rapid increase in the risks of such securities had an immediate global impact. Many financial institutions suddenly faced illiquidity since mortgage-backed securities were no longer saleable.
Financial Crisis Ensues
Saddled with mortgage-backed assets, both investment and commercial banks were unable to borrow freely in the money market. The disappearance of liquidity began to push several banks toward insolvency since they could not refinance their obligations. Collapsing asset prices then led to large losses. With bank solvency in doubt, liquidity became even scarcer.
The destructive interplay of illiquidity and insolvency eventually led to the bankruptcy of independent investment banks, which had been operating with extremely low capital ratios. Commercial banks, meanwhile, were placed in a similar predicament, further compounded by the risk of runs on their deposits. Inevitably banks became extremely conservative about further lending, and the collapse of securitization led to credit shortages.
Tightness of credit impacted on aggregate demand, leading to falling output, collapsing exports and rising unemployment. A full-blown financial crisis became a severe and widespread recession affecting both developed and developing countries.
At present large numbers of commercial banks in developed countries are effectively bankrupt, surviving purely because of state support of their capital and liquidity. Therefore, confronting the recession should also involve dealing with the systemic financial problems at the root of the crisis. Policies should tackle the failure of deregulated banking that combines commercial and investment functions. Policies should also deal with the macroeconomic imbalances that encouraged the speculative financial excesses of the last decade.
As Edward Kane (who predicted the S&L crisis years in advance, Kane, 1985) and others have noted, in the early 1990s, Congress repeated with Fannie and Freddie the mistake that caused the collapse of the S&L industry. That is, it gave government backing to private enterprises without adequately limiting the risks these companies could take. But the Fannie and Freddie case is a far worse political failure than the S&L debacle. First, taxpayers' losses will be much greater than in the S&L crisis. Second, in the S&L crisis, Congress might be excused for not recognizing that it should have imposed tighter limits on the risks assumed by government backed institutions. But while Congress was passing tough new banking regulation to fix the S&L crisis, the decision not to regulate the GSEs must have been a conscious decision on the part of the supporters of the GSEs in Congress. They decided not to regulate them so they could use GSE resources for their political constituencies.
How the Sub prime Market Collapsed?
Everything was going fine, during the early 2000s, interest rates fell, borrowing demand is increased, mortgage lenders were happy that they are expanding their business and making more and more profits, new lenders were entering the market...
And the story began, after the increase in US interest rates and decrease in the prices of US housing market the risk of borrowers to default is increased sharply. Defaults and foreclosure activity dramatically increased as ARM interest rates are reset higher. Subprime started to default and could not pay their debts back. But this crisis was not only a two-sided transaction. After sub primes could not pay back their debt, banks has written losses to their accounts. Under you can find some charts which explain the situation:
Role of Public Policy
Govt. has taken certain steps for the coping of these problems and for the betterment of the economy of the USA.
Steps Taken by Govt. to cope up with these Problems:
Policy makers - both at the state and national levels - have stepped in to attempt to soften the economic blow of the credit market crisis and the deteriorating housing sector. A wide variety of proposals have been introduced and/or adopted. Several of these are especially important.
First, in order to short-circuit the downward economic spiral, the Federal Reserve is easing monetary policy by injecting liquidity into the banking sector. Over the last six months, the Fed has reduced their fed funds interest rate target from 5.25% to 3.00%.
The Fed is also pushing lenders to tighten their lending standards. They propose lenders evaluate borrowers' ability to repay, document income and assets, eliminate prepayment penalties within a certain time period of an ARM reset date and establish escrow accounts for taxes and insurance.
In order to deal with the sub-prime ARM crisis, Secretary of the Treasury Henry Paulson is pushing for a system-wide mortgage restructuring plan (rate, term, balance) wherein large groups of borrowers could be helped. Treasury believes mortgage servicers do not have the capital and labor resources to recast each loan on a case by case basis.
And lawmakers also are currently drafting the Emergency Home Ownership and Mortgage Equity Protection Act which could allow bankruptcy judges to rewrite terms of mortgage contracts. In the short run, this would reduce the number of foreclosed homes for sale in the housing market, mitigating the decline in home prices. In the long run, giving bankruptcy courts the authority to modify mortgage contracts between borrowers and lenders would increase the uncertainty and therefore the risk related to mortgage investing.
- Laeven, L., and F. Valencia (2008). 'Systemic Banking Crises: A New Database'. IMF Working Paper WP/08/224. Washington, DC: IMF.
- Giles, C. (2008). 'The Vision Thing'. Financial Times, 26 November.
- Bicksler, J. L. (2008). 'The Sub-prime Mortgage Debacle and its Linkages to Corporate Governance'. International Journal of Disclosure and Governance, 5 (4): 295-300.
- Lin, J. Y. (2008). 'The Impact of the Financial Crisis on Developing Countries'. Paper presented at the Korea Development Institute, 31 October. Seoul.
- Taylor, J. B. (2009). 'The Financial Crisis and the Policy Responses: An Empirical Analysis of What Went Wrong', NBER Working Paper 14631. Cambridge, MA: National Bureau of Economic Research.
- Article "The Roots of the Global Financial Crisis"
- Article "The Political, Regulatory and Market Failures that Caused the US Financial Crisis: What are the Lessons