2008 Financial Crisis

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See all Bulls Reasons Bulls Perspectives The $1,300 trillion derivatives market 85% agree The $1,300 trillion derivatives market The $1,300 trillion derivatives market is an indicator of gross abuse of a system originally intended to hedge risk through the separation of risk and rewards associated with a security from the underlying security. Now $1,300 trillion is several times the global GDP... read more View or Edit Reason 7 votes 85% agree Smart money is buying 100% agree Smart money is buying Some of the best investors in the world who have recently become bullish, at least for the short/intermediate term: Warren Buffett , “Buy American. I Am.” The New York Times, October 17: A simple rule dictates my buying: Be fearful when others are greedy, and be... read more View or Edit Reason 1 votes 100% agree Buying on Valuation 0% agree Buying on Valuation Valuations have now been driven into the ground. In my view, there remains a 12.5% downside to recent intra days lows. It is a time when it is scary to invest; yet it is likely to be amongst the better investment opportunities through 2015. Two portfolio's can be viewed... read more View or Edit Reason 0 votes 0% agree Add your own Bulls Reason See all Bears Reasons Bears Perspectives Politicians unfit to remedy financial crisis, Palin example 94% agree Politicians unfit to remedy financial crisis, Palin example The markets are dirty; always have been, always will be. Some issues being discussed in the October 2, Vice President debate I have to take at face value because I am not an expert in those fields. When Governor Palin promises to “get rid of greed and corruption on... read more View or Edit Reason 19 votes 94% agree Bad news from almost every sector 100% agree Bad news from almost every sector The economic news over 6th Nov, 2008 has been just horrible: After the close yesterday, Cisco (CSCO) said orders in October fell off a cliff - down 9% from the year ago period - and forecast a 5-10% drop in revenues for the current quarter. Retailers this morning... read more View or Edit Reason 3 votes 100% agree Add your own Bears Reason Send the authors a comment or suggestion Be the first to make a suggestion See All Suggestions

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This article details the fallout within the Financial industry in 2008. For a definition of the term "credit crunch," see Credit Crunch (definition). For information on the 2007 Credit Crunch, see 2007 Credit Crunch

In 2008, a series of bank and insurance company failures triggered a financial crisis that effectively halted global credit markets and required unprecedented government intervention. Fannie Mae (FNM) and Freddie Mac (FRE) were both taken over by the government. Lehman Brothers declared bankruptcy on September 14th after failing to find a buyer. Bank of America agreed to purchase Merrill Lynch (MER), and American International Group (AIG) was saved by an $85 billion capital injection by the [[Federal Reserve|federal government.^[1] Shortly after, on September 25th, J P Morgan Chase (JPM) agreed to purchase the assets of Washington Mutual (WM) in what was the biggest bank failure in history.^[2] In fact, by September 17, 2008, more public corporations had filed for bankruptcy in the U.S. than in all of 2007.^[3] These failures caused a crisis of confidence that made banks reluctant to lend money amongst themselves, or for that matter, to anyone.

The crisis has its roots in real estate and the subprime lending crisis. Commercial and residential properties saw their values increase precipitously in a real estate boom that began in the 1990s and increased uninterrupted for nearly a decade. Increases in housing prices coincided with a period of government deregulation that not only allowed unqualified buyers to take out mortgages but also helped blend the lines between traditional investment banks and mortgage lenders. Real estate loans were spread throughout the financial system in the form of CDOs and other complex derivatives in order to disperse risk; however, when home values failed to rise and home owners failed to keep up with their payments, banks were forced to acknowledge huge write downs and write offs on these products. These write downs found several institutions at the brink of insolvency with many being forced to raise capital or go bankrupt.

[edit] Companies Involved

[edit] US Investment Banks

• Goldman Sachs
• Morgan Stanley
• Merrill Lynch
• Lehman Brothers

[edit] US Retail Banks

• Citigroup
• Wachovia Bank
• Washington Mutual
• Bank of America
• Wells Fargo

[edit] European Banks

• UBS
• Credit Suisse
• Deutsche Bank
• Royal Bank of Scotland
• HBOS
• ING
• Fortis (FORB-BT)

[edit] Mortgage Lenders

• Fannie Mae
• Freddie Mac

[edit] Precursors to the Credit Crisis

[edit] Moral Hazard created by U.S. Federal Government

The U.S. Federal Government chartered the two leading mortgage institutions at the center of the crisis, Fannie Mae in 1938 and Freddie Mac 1970.^[4] Fannie and Freddie were able to freely take on huge risks because US Government implicitly promised these institutions that it would make good on their debts. In the 1990s, although beginning in 1977, Congress pushed mortgage lenders, including Fannie and Freddie, to expand subprime lending, and with the implicit promise of federal backing, they happily obliged. With the creation of mortgage-backed securities, which decreases risk by spreading the risk, and the moral hazard created by government, subprime lending soared. Mortgage lenders began to take on huge risks and then passed them on as mortgage-backed securities, which were found in almost any kind of investment funds.

[edit] Subprime Lending

The concept of subprime lending (providing loans to borrowers with low credit ratings or poor loan repayment histories) gained favor in the 1990s to promote home ownership amongst lower income borrowers.^[5] For decades banks found themselves defending their lending standards to the public, many of which believed they unfairly discouraged home ownership for low income citizens. The passage and subsequent revision of the Community Reinvestment Act (which required banks to offer credit to their entire market area -- not just the affluent parts) was instrumental in prompting bank lending reform.^[6]. To account for lending to this higher risk group, lenders structured loans with higher interest rates to make up for the risk increase. Approximately 80% of these loans have adjustable-rate mortgages that started out with a teaser interest rate, which would increase significantly after an introductory period. ^[7]From 2004 to 2006, 21% of all mortgage originations were subprime, up from 9% from 1996 through 2004.^[8] As of December 2007, subprime ARMs represented 43% of all mortgage foreclosures in the U.S., and there was still an estimated $1.3 trillion in subprime mortgages outstanding.^[9][10]

[edit] Deregulation in the banking industry

In 1999, the Gramm-Leach-Bliley Act repealed the Glass-Steagall Act of 1933, which had previously enforced the separation of investment and commercial banking activities. For example, under Glass-Steagall, a bank could not offer investment services and originate loans. Repealing Glass-Steagall allowed banks to get into the lending business. Banks could work with mortgage loan origination companies to write loans to people without proper collateral and then sell the loans to investors.^[11] The loans were pooled together to create mortgage-backed securities and collateralized debt obligations . The repeal of the Glass-Steagall Act was lobbied for by banks like Citigroup for two decades. The groups spent more than $200 million in 1998 alone lobbying to this end.^[12]

[edit] Credit Ratings Agencies mis-rate mortgage securities

The 2008 financial crisis has exposed flaws in both the credit rating procedures and the incentives model for credit rating agencies. Credit rating agencies assign ratings to bonds and other debt instruments (such as the pooled subprime loans that were at the root of mortgage-backed securities). Credit rating agencies like Moody's and Standard & Poor's evaluate the likelihood that the debt will be paid back and assigns a letter ranking on a scale of AAA to B, CC, etc. Anything below BBB is considered speculative while a AAA rating is the highest credit rating available.^[13]

With the mortgage-backed securities created by investment banks, however, credit ratings agencies' ratings were off the mark as they assigned AAA ratings to what were by definition subprime and high risk loans. Ratings on these products were based on flawed mathematical models, which depended heavily on assumptions derived from historical data and the diversification of risk. With subprime loans and their pooled securities, however, very little data exists on which to make sound assumptions.^[14] As of July 2008, credit rating agencies had downgraded $1.9 trillion in mortgage backed securities to account for the lower repayment rates on subprime securities. Many of these securities were even downgraded to speculative grade ratings.^[15][16]

Another part of the reason credit ratings performed poorly in assessing the risk of mortgage-backed securities was a conflict of interest in their incentive system. These agencies earn revenues for the amount of securities they can rate, not the quality of their ratings. In 2005, more than 40% of Moody's (MCO) ratings revenue came from rating securitized debt.^[17]

[edit] Structured Products Spread Subprime Debt Throughout the Financial System

In the aftermath of the saving and loan crisis, mortgaged backed securities, pools of residential and commercial loans sold in the capital markets as bonds, provided firms with a more profitable strategy than traditional balance sheet lending (where banks held mortgages they originated to maturity). Lenders transferred loans into special purpose investment vehicles and sold these securities to other banks and institutional investors like pension funds, endowments, and governments thus off-setting long term risk exposure.

These securities were structured into debt tranches and assigned credit ratings so that investors could evaluate their risk and in turn demand an appropriate rate of return for buying it. Because rating agencies (Standard & Poors, Fitch, and Moodys) were independent to the banks, investors believed their classifications could be trusted to accurately assess pool level risks. Also, despite the fact that each pool had some risky loans, the overall portfolio should benefit from the diversified mix of loan sizes, asset types, geographic locations, and borrowers. Even in the event of unforeseen losses, it was unlikely purchasers of the highest rated tranches would lose their principal invested (and purchasers of lower rated tranches would receive a higher yield for assuming more risk).

As the model gained popularity, European banks utilized it to varying degrees, with some firms such as UBS, Deutsche Bank, and Credit Suisse originating and selling loans in the United States through their American banking arms while others focused on regional markets, which catered to a more localized investor base. In both cases, banking institutions suffered when sub-prime loan defaults prompted a crisis of confidence in the global investment community, calling lending standards and credit ratings associated with structured debt instruments into question. The sub-prime losses led many to believe that ratings connect not only to structured products but corporate and sovereign debt could not be relied upon.

The precipitous decline in investor faith led to a “flight to quality,” where investors either discontinued purchasing asset-backed bonds or demanded significantly higher returns for the perceived increase in risk, forcing banks to reluctantly realize significant write-downs when they “marked,” or recorded, unsold securities to their current market value. Many of these marks have been called into question as critics argue that banks are assigning unrealistically high values to products without significant demand. The succession of billion dollar write-downs, which total more than half a trillion dollars globally, has prompted a financial avalanche of sorts, causing wary fund managers, businesses, and even individuals to withdraw capital or close their accounts (which banks largely rely upon to fund lending operations and proprietary investments). After sustaining significant losses in value, many banks have found themselves hard pressed to fund daily operations and have had to raise equity in the private markets. These firms have pursued debt and common stock issuances and cut dividends, all in the name of adding capital to their balance sheets.^[18]

[edit] Federal Government Bailout

On Monday, September 29 2008, an "Emergency Economic Stabilization Act" was put to the House of Representatives. Known as the "bailout bill," the act was put together by a host of federal government officials. The legislation would give Treasury Secretary Henry Paulson authority over $700 billion to buy failing financial assets such as mortgage backed securities, whose plummeting values caused credit markets to freeze.

The bill was overturned in its original form. The bill's supporters argued it would stave off a collapse of the U.S. economy, but its opponents argued it was hastily drafted, placed too great a burden on taxpayers who were not responsible for Wall Street's irresponsibility, and was not popular with the nation at large (politicians took this into special consideration given the proximity of November's elections).^[19]In the aftermath of the bill's failure, $1.2 trillion was erased from the market value of American stocks as frightened investors fled for the safety of gold and government Treasury bonds. The Dow Jones Industrial Average fell 777 points, the largest one day decline since the index was first published in 1896. The S&P 500 fell almost 9%, a drop not seen in two decades.

After the failure in the House, the Senate acted, amending the bill and passing it by a 74 to 25 margin on Wednesday, October 1. The bill was amended to include over $150 billion in tax breaks to individuals and businesses. These additions were designed to help win the twelve additional votes needed to get the bailout plan through the House of Representatives. Other additions included a temporary increase in the amount of bank deposits covered by the Federal Deposit Insurance Corporation (FDIC), to $250,000 from $100,000, and legislation requiring insurers to treat mental health conditions more like general health problems.^[20]

On Friday, October 3rd, the House of Representatives passed the amended version of the bill by a wide margin. The vote tally was:

Within an hour of the Congressional passage of the act, it was signed into law by President George W. Bush.^[21]

[edit] The Bailout Bill

Details of the proposal included:^[22]

• The Troubled Assets Relief Program (TARP): The bill authorizes $700 billion for this fund, which will be used to buy and hold troubled loan-based assets, many of which are tied to home prices in the slumping U.S. housing market. The Treasury plans to hire asset managers who will determine what loans to buy and how to do it, working out the details of pricing and purchasing procedures with the Treasury. The Treasury must set guidelines on the pricing of these assets within 45 days, as well as the procedures for purchasing assets, selecting asset managers, and identifying which troubled assets to buy. The Treasury must also purchase assets at the lowest price, either through auction or directly from institutions. First will be the simplest assets, like mortgage backed securities, to be followed by more complex securities and derivatives.

• Executive compensation: This part of the bill was initially opposed by Paulson, but was conceded in the interests of passing the act through Congress. The legislation will restrict executive compensation for certain companies that sell assets to the U.S. Treasury. If the Treasury buys assets from a failing company directly, then there will be no "golden parachutes" for the outgoing executives. Also, companies that sell more than $300 million of assets to Treasury won't be allowed to make any new golden-parachute payments to top executives.

• Equity stakes: This part of the bill opens up the possibility that ultimately the Treasury, and U.S. taxpayers, could profit from the bailout. The Treasury will receive warrants in companies that participate in the program. When a company sells its assets in an auction, the Treasury will get some amount of nonvoting warrants; but if the Treasury buys assets directly from a firm, it could get a majority equity stake in that company.

• Oversight: The Troubled Asset Relief Program will be overseen by Congress (a bipartisan committee). The commission will receive reports from the Treasury every 30 days. Additional oversight will come from a board that includes the heads of the Treasury, the Federal Reserve, the Securities and Exchange Commission, the Housing and Urban Development Department and the Federal Housing Finance Agency.

• Protecting taxpayers: If after five years the government has a net loss, the president will submit a legislative proposal to seek reimbursement from the financial institutions that participated.

• Help for homeowners: The Treasury will buy mortgage-backed securities, mortgages, and other assets secured by residential real estate. As an investor in these loans, the Treasury will use its position to minimize foreclosure and encourage the solvency of the loans. Essentially, the Treasury will cut some slack to homeowners who have fallen behind on their payments, something that commercial lenders in a credit squeeze have not been able to do.

• Insurance: The Treasury must initiate a program to insure mortgage-backed securities. Participating financial services firms would pay the government a fee in return for insuring their assets against any future losses.

• Accounting: The Securities and Exchange Commission will be required to study mark-to-market accounting standards, which require that, when reporting the value of their assets, firms use their true market value. In 2008, this has led to major write downs for many financial institutions because the value of so many credit-based assets has fallen steeply.

[edit] International Involvement

The credit crisis has had a staggering impact on the financial services sector globally, leaving many foreign banks especially vulnerable to collapse and challenging local governments to respond quickly to the rapid de-stabilization of their economies. Like their American counterparts, these banking institutions have generally experienced erosion of value as investors become increasingly concerned about their over-exposure to complex securitized mortgage products in the wake of sub-prime defaults in the United States.

[edit] Europe

The first bank to experience such a collapse was the UK based Northern Rock, which was nationalized in February 2008 ^[23] by the British government after failing to raise sufficient capital to meet its borrowing requirements. ^[24] Nationalization was viewed reluctantly by officials as the only way to avoid bankruptcy after negotiations to buy the beleaguered institution failed to gain enough traction in the private sector (private equity firm J.C. Flowers and a consortium lead by billionaire Richard Branson both considered purchasing the bank). The government assumed all of Northern Rock’s debt obligations (approximately $90 billion pounds), signaling the first major UK bank intervention since the 1970s.

[edit] Government Intervention in European Markets

Since then, local governments throughout the Euro Zone have taken aggressive measures to provide a lifeline to beleaguered institutions, fearing the failure of one could lead to successive collapses not just in their countries but throughout the continent. Bradford & Bingley, another UK lender and Glitnir (the third largest lender in Iceland), were both nationalized by their respective governments. The governments of Belgium, Luxembourg, and the Netherlands partially nationalized financial conglomerate Fortis, buying major interests in the subsidiaries domiciled in their respective countries. ^[25] Similarly, the Belgian and French governments infused approximately $9 billion in Dexia with the German government (along with a collective of banks and insurers) agreeing to a $68 billion bailout for Hypo Real Estate, the large lender.^[26]

In what may be the most ambitious attempt to restore normalcy to the European markets, the government of Ireland announced that it would guarantee payments on as much as $563 billion in bank debt (including securities, short-term borrowings, and individual deposits), which represents twice the country’s gross domestic product. ^[27] Such bold moves have raised concerns amongst officials elsewhere, particularly in the UK, who fear guarantees of this magnitude incentivize investors (currently lacking such guarantees) to transfer money out of their countries and into Ireland. The German government responded by guaranteeing all private saving accounts in the country but declined to insure other bank liabilities.^[28]

These issues have spawned ongoing debates on the extent to which European countries should develop a more holistic approach to government intervention in financial markets. In an effort to establish a more unified front, leaders from France, Britain, Germany, and Italy held a financial summit in October, 2008 hosted by the President of France, Nicolas Sarkozy. ^[29] Though committed to informal coordination, European leaders (particularly in Germany) have made it clear that they do not intend to establish a pan-European fund mirroring the US government bailout or a new governing body to manage the process.

[edit] UK Leads Government Effort to Purchase Bank Stocks

Later that month, Gordon Brown, UK’s Prime Minister, announced his government’s intentions to take major stakes in the Royal Bank of Scotland, Lloyds Tsb Group (LYG), and Heritage Financial Group (HBOS) in a deal valued at $64 billion dollars. Along with 60% ownership of Royal Bank of Scotland and 43.5% ownership of Lloyds Tsb Group (LYG) and Heritage Financial Group (HBOS), the government will have decision-making authority (including the distribution of dividends), control seats on the board of directors, and have the authority to limit executive compensation. ^[30] His decision sent a strong signal to the capital markets, reaffirming his government’s commitment to capitalizing banks and restoring order to the global economy. What’s more, the move established Brown as a pivotal actor in the financial landscape. ^[31]

Shortly after his announcement, the US Treasury Secretary decided as much as $250 billion dollars (from the $700 billion bailout) would be allocated to assume large equity positions in domestic banks. Fifteen Euro Zone countries (including Germany, France, Italy, and Spain) followed in tow, using Gordon’s plan as the blueprint of a comprehensive rescue initiative where each government would provide interbank lending guarantees and offer capital to cash strapped institutions in return for ownership interests. ^[32] Subsequently, President George Bush and European leaders agreed that ongoing talks between the countries would be necessary to gauge the effectivness of their respective interventions and explore global regulatory reform.^[33]

Bank executives, in many cases reluctant to cede control over their companies, find themselves at a difficult impasse, preferring to raise money privately. However, private investors are reluctant to over-commit under such uncertain circumstances, making the government the last resort for many. After originally refusing capital from the government of Netherlands, ING Groep N.V. (ING) (the largest lender in the region) accepted a $13.5 billion infusion to stay afloat. ^[34] UBS, the largest Swiss bank, sold a 9% interest to its government, receiving a $5.4 billion boost after writing down over $40 billion in losses related to mortgages and other asset-backed securities. ^[35]

[edit] European Central Bank

Given the gravity of the financial downturn, the European Central Bank (ECB), an institution established to preserve the purchasing power of the euro, has been called upon, through monetary policy, to play an uncharacteristically active role alongside local governments to stabilize markets.^[36] Shortly after the bankruptcy of Lehman Brothers, it provided $180 billion in overnight dollar loans after the currency swap markets (generally used to convert euros or pounds received from the central bank into dollars to pay dollar-denominated debts) dried up. ^[37] Through its overnight lending operations, the ECB has also been a source of liquidity, injecting hundreds of billions of dollars into the banking system as well as cutting the benchmark rate in October (along with the US Federal Reserve Bank). In an effort to prevent further destabilization, the ECB even lent the government of Hungary approximately $7 billion, a country particularly vulnerable to fluctuations in the currencies markets due to its high concentration of foreign debt. ^[38]

[edit] Russia

The erosion of confidence in global markets has led to a massive sell off of Russian stocks as investors withdraw capital from the country. Economic uncertainty compounded already existing concerns that surfaced after Russia invaded Georgia in August 2008. ^[39] Since then, over $63 billion dollars of investment capital has left the country. Regulators stopped trading on September 17th on the country’s main exchanges after equities saw their biggest drop since 1998 (the Micex fell nearly 18% the day before and as of October 2008 was 68% off its peak). ^[40]The Central Bank subsequently injected $14 billion into the financial system and set aside approximately $50 billion dollars to provide support to cash strapped businesses that have seen their values plummet rapidly. Wealthy oligarchs (who in many cases, made their money by utilizing freely available credit) have been particularly hard hit as borrowing costs increase. $48 billion dollars of debt obligations are due by the end 2008. Bloomberg News calculated that the richest 25 Russians lost a collective $230 billion since the market’s peak.

[edit] Asia

Asian financial institutions had little exposure to the esoteric financial instruments that have sent the world markets into spiral. This is largely due to the fact that having experienced their own financial crisis ten years earlier, firms learned to take a more measured risk management approach, relying less on leverage and maintaining higher liquidity ratios. As a result, Asian firms (particular in Japan) have been well positioned to make strategic investments in the finance industry (with Mitsubishi UFJ buying a 21% stake in Morgan Stanley and Nomura Holdings Inc ADR (NMR) purchasing Lehman’s Asia platform).^[41]

Even so, Asian governments are aware that their countries are not immune to general market dynamics and witnessed their stock markets dip as banks, fearful of counterparty risk, constricted credit. ^[42]Moving in lock step with Europe, the governments of Hong Kong, Malaysia, and Singapore then responded by guaranteeing all bank deposits in their respective countries to prevent runs on the banking system. The government of South Korea, Asia’s fourth largest economy, unveiled a $130 billion bailout plan designed to help its banks pay international debts. Such measures were considered necessary because the won has fallen to a 10 year low, placing strains on local institutions that borrow in dollars from international institutions.^[43]

[edit] Middle East

The United Arab Emirates government has seen its wealth impacted as sizable investments in US bank stocks continue to lose value. Abu Dhabi Investment Authority, the world’s largest sovereign wealth fund, invested $7.5 billion dollars in Citigroup, taking on a 4.9% ownership interest in the company.^[44]Other countries, including Saudi Arabia, made large bets on banks in the early stages of the downturn, reasoning their battered stocks made them attractive long term investments. But continued volatility in the markets has resulted in even deeper losses. While the oil rich nations, which have experienced rapid growth as oil prices hit record highs, are well positioned to absorb these losses, general concerns persist regarding the depth of their local markets as credit becomes less available and oil less expensive. Both Saudi Arabia and Dubai have seen sell offs in their exchanges (with Saudi’s shares losing 45% of their value), as continued uncertainty caused uneasiness amongst both local and foreign investors. ^[45]The United Arab Emirates government has taken measures such as establishing a $13.6 billion emergency lending facility for banks, reducing its overnight lending rate, and guaranteeing domestic bank deposits and inter-bank lending to restore faith in its markets.^[46]

[edit] Pakistan

Political unrest and ongoing security concerns in the midst of a global economic crisis has led to a significant flight of capital out of Pakistan despite the central bank's efforts to restore faith by pumping cash into the system and despite new rules prohibiting a sell-off in the Karachi stock market. As a result, the country has seen a severe deduction of foreign-exchange reserves (approximately half of November 2007 reserves). Without access to additional capital, the government may be vulnerable to a default and has actively sought out support from China and Saudi Arabia (in the form of oil concessions). In October 2008, the World Bank and Asian Development Bank committed $1.5 billion dollars worth of financing while The Islamic Development Bank and the UK’s Department for International Development each pledged $1 billion, respectively. Without additional aid, analysts believe Pakistan will have to turn to the IMF as a source of capital. ^[47]

[edit] Implications of the Crisis

Bank Lending The perceived failure of banks to manage risk has led to a massive sell-off of their stocks, further draining them of liquidity, and leading many to the brink of insolvency. Even as Central Banks inject cash into the global economy (by providing large short-term loans to financial institutions), interbank lending has come to a grinding halt because banks are fearful of dispensing capital to unstable counterparties or over-extending themselves while experiencing losses at their own firms. ^[48] Their reluctance to lend, even amongst each other, freezes the credit markets, making it difficult for corporations and individuals, even those with a consistent track record of repayment or strong credit scores, to use debt to finance purchases of everything from equipment to auto loans. The decision of the US and European governments to take major stakes in financial institutions, a sign they will not let them fail, may be a catalyst in convincing the finance industry it is again safe to lend.

Real Estate In the case of real estate, there is significant downward pressure on commercial and residential values. Housing supply, especially in secondary and tertiary markets, has increased significantly in 2008 due not only to the increase in foreclosures but the inability of developers and property owners to sell or refinance projects in the midst of the credit freeze. This is particularly troubling considering the average American's largest investment is in their home. If real estate prices continue to decline, homeowner equity will be eroded and in some cases wiped out altogether. In the event credit does not become more available in the near future, as owners' debt obligations come to maturity (especially in high leverage interest only deals), many will default due to their inability to make the balloon payment. It appears US policymakers are taking proactive measures to prevent a pricing free fall and are exploring a second bailout to explicitly address the real estate market. One key element of such a plan would involve re-negotiating mortgage terms to stem the number of foreclosures. But the extent of involvement of banks and borrowers will have to be negotiated by legislative bodies. ^[49]

Credit Default Swaps The credit default swap market, a loosely regulated body of financial firms that buy and sell insurance to protect against losses on instruments such as collateralized debt obligations and asset-backed securities will receive more scrutiny from governmental authorities as the size and impact of these contracts on the larger financial markets comes into better focus. Though the exact size of the market is up for debate, there is no question that it is in the trillions (aggressive estimates put the market at $62 trillion, far larger than the securities it insures). The CDS market, much like the general insurance industry, was created so that financial institutions could offset exposure to securities by having their losses insured. Firms paid premiums to counterparties that would cover loses on the face value of instruments such as bonds. But since the cost of these premiums varied depending on the perceived likelihood of default and extent of loss, they were traded and viewed as an indicator of each bank's stability. In some cases, investment vehicles shorted financial stocks (betting on a decline in value) even as they provided CDS protection to the same firms (which in turn became more expensive as bank stability was called into question). What's worse, banks were both buyers and sellers of CDS, meaning the failure of one institution could be enough to send ripple effects to several other firms that sold protection to it. After the collapse of firms like Bear Stearns and Lehman Brothers, providers of CDS protection demanded more collateral from their respective counterparties to execute contracts. Federal prosecutors and New York's Attorney General are coordinating a joint effort to further investigate the market and any abuses that occurred in the sale of swaps. Though findings of the investigation have not been released, parties involved expect significant regulatory reform to follow shortly thereafter. ^[50]

[edit] References

1. ↑ "Fed's $85 Billion Loan Rescues Insurer, NY Times, September 17, 2008
2. ↑ "JPMorgan buys WaMu", CNN Money, September 25, 2008
3. ↑ "2007 Public Company Bankruptcies Surpassed, According to BankruptcyData.com", MarketWatch, September 17, 2008
4. ↑ Federal Housing Finance Agency, Government Sponsored Enterprises
5. ↑ NY Times, Fannie Mae Eases Credit to Aid Mortgage Lending," 9/30/99
6. ↑ Wikipedia Community Reinvestment Act Page
7. ↑ NPR, "Subprime loans: a primer", 3/23/07
8. ↑ USA Today, "Subprime woes could spill over into other sectors," March 15, 2007
9. ↑ Mortgage Bankers Association, "Delinquencies and Foreclosures Increase in Lastest MBA National Deliquency Survey, "12/7/07
10. ↑ Bloomberg, "Subprime Losses are Big, Exaggerated by Some"
11. ↑ "Financial Deregulation Was A Costly Blunder", Chattanoogan
12. ↑ Glass-Steagall Wikipedia Page
13. ↑ Wikipedia Credit Rating Page
14. ↑ "Subprime crisis: The role of credit rating agencies", Die Bank
15. ↑ Wikipedia Page for Role of credit rating agencies in the subprime crisis
16. ↑ "S&P May Cut $12 Billion of Subprime Mortgage Bonds", Bloomberg, July 10, 2007
17. ↑ "Regulation-induced innovation: The role of the central bank in the subprime crisis", Knowledge @ Wharton, July 9, 2008
18. ↑ Wikipedia Sovereign Wealth Fund Page
19. ↑ The New York Times, "House Rejects Bailout Package, 228-205; Stocks Plunge," 9/29/2008
20. ↑ The New York Times, "Pressure Builds on House After Senate Backs Bailout," 10/1/08
21. ↑ The New York Times, "Bush Signs Rescue Bill After House Vote," 10/3/08
22. ↑ The Wall Street Journal, "Shape of Massive Bailout Bill Starts to Develop Definition", 9/29/2008
23. ↑ "Bloomberg","U.K. Government Starts Northern Rock Nationalization (Update5)", 02/18/08
24. ↑ Economist, "Lessons of the Fall,"10/18/07
25. ↑ MarketWatch, "Fortis Gets $16.4 billion in Partial Privatization," 9/29/08
26. ↑ Reuters, "Germany Agrees Bank Rescue and Guarantees Savings," 10/5/08
27. ↑ The Wall Street Journal, "Ireland, France Aid Banks, as Jitters Go Global,"10/1/08
28. ↑ The New York Times, “Germany Moves to Shore Up Confidence in the Economy,” 10/5/08
29. ↑ The Financial Times, "European Leaders Offer United Front On Crisis," 10/4/08
30. ↑ Business-Standard, "RBS, HBOS, Lloyds, get $64 Billion,"10/14/08
31. ↑ Business Week, "Gordon Brown Saves Banks----And Himself,"10/14/08
32. ↑ Guardian, "Eurozone Countries Agree on Brown Rescue Plan," 10/13/08
33. ↑ &st=cse&oref=slogin, NY Times, "Bush Calls World Leaders to Summit on Markets," 10/22/08
34. ↑ Reuters, "Dutch State Injects 10bln Euros into ING,"10/20/08
35. ↑ NY Times, "UBS Given an Infusion of Capital," 10/16/08
36. ↑ The European Central Bank
37. ↑ central bank&st=cse, NY Times, "Credit Crisis Alters Focus of European Central Bank European,"10/16/08
38. ↑ NY Times, "European Central Bank Lends to Hungary,"10/16/2008
39. ↑ Forbes, "Inside Russia's Stock Market Panic,"9/18/08
40. ↑ Forbes, "Behind the Russian Stock Market Meltdown," 9/17/08
41. ↑ TheStreet.com, "Morgan Stanley Lands on Its Feet, For Now," 10/13/08
42. ↑ Time, 10/20/08
43. ↑ Radio Australia, "South Korea Hopes Bailout Will Stabilise Currency," 10/20/08
44. ↑ Wikipedia, "Abu Dhabi Investment Authority", 09/08
45. ↑ Wall Street Journal, UAE Steps Up Bid to Aid its Banks," 10/15/08
46. ↑ Kuwait Times, "UE Guarantees Bank Deposits," 10/13/08
47. ↑ Pakistan Asks I.M.F. for Aid,"NY Times", 10/22/08
48. ↑ Associated Press, "How Do You Inject Money Into the Economy," 6/16/07
49. ↑ CNBC", Housing Bailout Will Be On Next Agenda,"10/20/08
50. ↑ Associated Press, "Meltdown 101:Credit Default Swaps, 10/21/08