The Global Financial Crisis of 2008: Causes, Consequences, and Contagion Effects, Appunti di Economia Politica

Scarica The Global Financial Crisis of 2008: Causes, Consequences, and Contagion Effects e più Appunti in PDF di Economia Politica solo su Docsity! 2nd March 2009 Global Financial Crisis By Jitendra Garg MS (Finance), CFA Global Financial Crisis 2nd March 2009 Page 2 Table of Contents Overview ............................................................................................................................ 3 The Origin of the Subprime Mortgage Crisis ................................................................ 3 Transformation of Subprime Mortgage Crisis into Global Financial Crisis .............. 4 Bursting the Subprime-CDO-CDS Bubble ..................................................................... 5 Contagion Effects on world Economy ............................................................................. 5 Deeper problems and Dramatic Measures ..................................................................... 6 Global Financial Crisis 2nd March 2009 Page 5 electronic shadow banks set up by investment and commercial banks to offload potentially risky CDOs from the banks' balance sheets. And indeed, the volume of CDS has exploded with nuclear force, nearly doubling every year since 2001 to reach a recent peak of $62 trillion at the end of 2007, before receding to $54.6 trillion as of June 30, 2008 according to ISDA. But why did banks and other financial institutions buy these dirty assets? Part of the reason lies in rating agencies. These agencies are paid to rate the complex products of financial institutions for their riskiness, nothing more than that. If they rate some securities favourably vis-a-vis the other, that means there is little chance of losing money if someone invests in that particular security. Apart from it, the bank’s SIVs make money from marking up and selling the CDOs as well as from insuring them at an additional charge with credit debt swaps. It is therefore not surprising that mainline investment and commercial banks experienced compound profit growth of more than 20 percent per year collectively for each year from 2004 through 2006—i.e., roughly the period of the most explosive growth of subprime mortgages bundled with CDOs. Bursting the Subprime-CDO-CDS Bubble The rate resets on the subprime & adjustable rate mortgages have increased the monthly mortgages payments typically by 25% & upwards. Declining housing prices coupled with increased rates meant that they could not reset their mortgage terms. As a result, defaults increased & houses went into repossessions & foreclosures. By mid-2006 it had become clear that the subprime mortgage market was in freefall. By late summer 2007 it was estimated that there would be two to three million potential foreclosures over the next few years. The value of subprime mortgages quickly plummeted and with them many of those CDOs in which they were imbedded. Consequently, all synthetic CDOs created in form of CDS came under high pressure of default & spread of CDS had increased drastically. The Crisis Takes Hold All entities having exposure in these instruments have faced redemption pressure & due to settlement of all these liabilities; many of biggest financial institutions like Lehman Brothers, Merrill Lynch, AIG, Fortis Group, Wachovia Bear Stearns, Freddie Mac, Citigroup Washington Mutual, Fannie Mae and so on have gone bankrupt or sold or bail out by Fed or cried for help. The Lehman brothers have outstanding exposure of US$597 bn at the time of filing bankruptcy and the same figure was US$441bn for A.I.G. Bear Stearns had sold to J.P. Morgan and the Fed could not let Bear Stearns enter bankruptcy because and only because the billions of dollars of credit default swaps on its books would be wiped out. All the banks and institutions that had insurance written by Bear would not be able to say that they were insured or hedged anymore and they would have to write-down billions and billions of dollars in losses that they've been carrying at higher values because they could say that they were insured for those losses. The counterparty risk that all Bear's trading partners were exposed to was so far and wide, and so deep, that if Bear was to enter bankruptcy it would take years to sort out the risk and losses. The severity of the problem is evident by the fact that major banks and financial institutions which borrowed and invested heavily in MBS & related derivatives based on these MBS, have reported losses of more than US$500 billion till now & this is expected to touch US$1 trillion due to spiral effect. Contagion Effects on world Economy All these events have created a cascading effect and crores of people have lost their jobs or faced decline in their salaries. Due to fall in creditability & liquidity, banks have discontinued their previous policy of proving credit with free hands. Consequently, demand in the U.S. which mainly depends on credit has come down & private consumption which constitutes over two-third of GDP went for a tail spin. Further, those economies like China & Japan and so on, which mainly depend on exports to the U.S. has also come into trouble. All this have decreased the demand for goods & services in different parts of the world. Accordingly, due to reduction in Global Financial Crisis 2nd March 2009 Page 6 industrial production & demand; oil prices after touching a height of US$147/b have come down to US$42.95/b (as on 26 Feb. 09) and world trade has also decreased. Thus some of big economies have registered negative growth & whole world including emerging nations are facing slowdown in their GDP growth rate. Simultaneously, world stock markets have lost approximately 40% of their value as on Jan. 2008 and in all, the slide from the height of the stock markets had wiped out more than US$8 trillion in wealth. Deeper problems and Dramatic Measures The bleeding in the stock market stopped only after a huge bailout plan of US$700bn being announced by the federal govt. on Sept. 18, 2008. Other countries have also taken measures in response to this crisis & more than one trillion dollars have injected in world markets by respective govts. to restore the confidence in financial system. Apart from it, U.S. has also announced a stimulus package of US$789bn after Baraq Obama has taken over and key interest rates in world market have decreased dramatically to boost the world economy. Others measures have also taken in forms of tax cut & subsidies. -----------------------------------------------------------------------------------------------------------------