2008 Financial Crisis

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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 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 the investment and banking industry lowering lending standards to market mortgages to unqualified buyers allowing them to take out mortgages while at the same time government deregulation blended 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.

Companies Involved

US Investment Banks

US Retail Banks

Precursors to the Credit Crisis

For 50 years after WWII, the U.S. housing market grew steadily with just a few set backs as prices increased. The government policies during this era had their roots in the agencies and government entities created in reaction to the massive mortgage foreclosures that occurred during the great depression. During 1930's Great Depression the US had experienced a greater mortgage crisis than the one we are experiencing now. 1933, about half of mortgage debt was in default, the unemployment rate had reached about 25 percent. Thousands of banks and savings and loans had failed. The amount of annual mortgage lending had dropped about 80 percent, as had private residential construction. States were enacting moratoriums on foreclosures. In response to this, the Home Owners Lending Corporation (HOLC) was created in 1933. The average borrower that the HOLC eventually refinanced was two years' delinquent on the original mortgage and about three years behind on property taxes. The HOLC was a created to handle the immediate problem of mortgage foreclosures. Congress created the Federal Housing Administration (FHA) in 1933 as a long term solution for stabilizing and managing the housing market and it chartered Fannie Mae in 1938 to facilitate the home mortgage lending market. In the post WWII era government policies continued to encourage homeownership. Primary among these policies to facilitate home lending was establishment of two Government Sponsored Enterprises (GSEs). The U.S. Federal Government chartered two leading mortgage institutions crisis, Fannie Mae (created as a government agency in 1938) which was charted as a private corporation in 1968 and Freddie Mac 1970.[4] 6 Fannie Mae operates in the U.S. secondary mortgage market. Rather than making home loans directly with consumers, Fannie works with mortgage bankers, brokers, and other primary mortgage market partners to help ensure they have funds to lend to home buyers at affordable rates. Fannie funds mortgage investments primarily by issuing debt securities in the domestic and international capital markets. Freddie Mac was charted by Congress in 1970 by the “Federal Home Loan Mortgage Corporation Act.” Freddie Mac's purpose is: (1) to provide stability in the secondary market for residential mortgages; (2) to respond appropriately to the private capital market; (3) to provide ongoing assistance to the secondary market for residential mortgages (including activities relating to mortgages on housing for low- and moderate-income families involving a reasonable economic return that may be less than the return earned on other activities) by increasing the liquidity of mortgage investments and improving the distribution of investment capital available for residential mortgage financing; and (4) to promote access to mortgage credit throughout the Nation (including central cities, rural areas, and underserved areas) by increasing the liquidity of mortgage investments and improving the distribution of investment capital available for residential mortgage financing. 7

In the 1990s Congress urged the GSEs, particularly Fannie and Freddie, to acquire documented loans made to borrowers that were considered a bit more risky. By doing this it was hoped than an additional 3% of borrowers could qualify for a Fannie and Freddie loan. The objective was to take home ownership in the US from 66% of the populace to 70%. [4] Originally backed by the Democrats and the Clinton Administration this goal was further embraced by the Bush Administration which continually emphasized that we were now an "Ownership Society". The Fed (under Alan Greenspan) abetted the availability of cheap money in the 2003-2006 time-frame by keeping the Fed Funds rate relatively low. As this environment developed, it should be noted that the foreclosure rate on a conforming Fannie and Freddie insured loan barely increased. Fannie and Freddie’s impact on the financial market was significant. As they acquired more and more mortgages, they increased the securitization of the mortgages into AAA rated mortgage backed securities (MBS). The cash received from this securitization was used to support the purchase of even more mortgages, and more MBS. By the end of 2008 Fannie and Freddie held or guaranteed 5 trillion or about half the US mortgage market.

The market for debt securitization was massive and the investment banking community (Goldman Sachs, Bear Stearns, Lehmann Brothers, Citicorp, Merrill Lynch) was competing hard with the GSE’s. The investment bankers believed that securitization reflects innovation in the financial markets at its best. Pooling assets and using the cash flows to back securities allows originators to unlock the value of illiquid assets and provide consumers lower borrowing costs at the same time. MBS and ABS securities offer investors with an array of high quality fixed-income products with attractive yields. The popularity of this market among issuers and investors has grown dramatically since its inception 30 years ago to $6.6 trillion in outstanding MBS/ABS in 2003. By 2008 it was at 14 trillion. The success of the securitization industry has helped many individuals with subprime credit histories obtain credit. The Investment community believes securitization allowed more subprime loans to be made because it provides lenders an efficient way to manage credit risk. Secondary market purchasers of loans, traders of securitized bonds and investors are not in a position to control origination practices loan-by-loan. The investment community in 2003 urged Congress to move with great care as it addressed the problem of predatory lending. They believed the secondary markets were a tremendous success story that helped democratize credit. [5]

As securitization of mortgages increased the Investment banks urged the mortgage lending industry (Countrywide, Washington Mutual, New Century Financial, Wells Fargo, Household Finance, Quikloans and many others), to increase their loan volumes. They did this by embracing the sub-prime borrower and issuing Alt-A (limited documentation) loans. And why not? The investment banks appetite for loans to securitize was ravenous. [6]

The mortgage and investment banking community continued to believe in securitization as way to reduce risk. The share of MBSs backed by subprime and Alt-A loans increased dramatically in the last decade. From 1996 to 2006 the share of subprime and Alt-A MBSs rose from 47% to 71% of total private sector MBS issuances. [7]

Mortgages were further dispersed into securitization structures called Collateral Debt Obligations (CDO’s). These were complicated securities designed to further reduce the risk of mortgage debt as well as consumer credit debt into slices of securities called “tranches”. A description of a CDO in a 2004 article describes the complicated nature of CDO’s: “Even though the motives behind the creation of each CDO differ widely, the principles underlying the structuring of a transaction remain similar. At the heart of these principles is the division or slicing of the credit risk of the reference portfolio into different classes, known as tranches. In accordance with its seniority, each tranche enjoys rights and priorities concerning payments generated by its collateral. Alternatively known as a waterfall structure, this is the process whereby in bankruptcy the proceeds from liquidated cash CDO assets will first be used to meet the claims of the most senior, triple-A rated debt tranche. Only then will proceeds flow to the next most senior tranche of notes, and so on. The most junior tranche within this waterfall structure is the equity piece, sometimes referred to as the ‘first-loss piece’, which is generally unrated and will account for anything between 2% and 15% of a CDO’s total capital structure. To compensate for their subordination within the cash waterfall, investors in the equity class of CDOs generally look for returns of between 15% and 20%. Equity tranches of CDOs can be placed with investors attracted by the high returns available. Indeed, a Fitch report published in February 2004 comments: “As markets have developed and the number of potential investors has grown, the markets have become more capable of absorbing the riskier pieces of an issue.” In practice, however, the equity tranches of CDOs are still often bought and held by originators. A key component of the tranching structure of CDOs is the use of coverage tests embedded into the covenants of deals and aimed at maintaining a minimum level of credit quality and therefore protection for note-holders. Coverage tests can include rate coverage ratios, over-collateralisation (OC) ratios and par ratios. In the event of these thresholds not being maintained on a payment date, the manager would generally be required to liquidate sufficient collateral to ensure that the ratios are satisfied. There are no predetermined rules on how many tranches an individual CDO may contain. The minimum is usually three, and although there is no maximum, the Aria CDO launched in June 2004 by Axa Investment Managers, which references a pool of 140 corporate names, is exceptional in that it is divided into 28 tranches denominated in five currencies – Swiss francs, sterling, dollars, euros and yen – and incorporating fixed, floating and inflation-linked tranches. “

The article also provided the above graphic to illustrate the structure of a typical CDO. Of interest is that the “AAA” rated tranche of the CDO was no doubt comprised of a significant amount of sub-prime and Alt-A mortgages.


A key question in the securitization process was how did almost all the securities being issued get rated AAA? Particularly, when as cited previously, 71% of all mortgages issued by the private mortgage industry in 2006 were sub-prime or Alt-A loans. The debt rating companies such as Moody’s, McGraw Hill’s Standard and Poor’s and Fitch were the leading agencies providing the ratings on the various asset backed securities being produced by the investment banks. And high rated securities were essential to the entire system: For every dollar of equity that financial companies are required to hold for bonds rated AAA, $3 is needed for bonds rated BBB, and $11 is needed for bonds rated just below investment grade (BB). For banks, the sensitivity of capital requirements to ratings is generally even more extreme. Since the ratings determine required capital, they have a profound influence on how financial institutions invest. And every actor in the financial system has every incentive to group and slice assets in ways that maximize not their fundamental soundness but their rating. Indeed, that is the entire rationale behind the $6 trillion structured-finance business. Subprime mortgages (and all manner of other risky loans) held directly by financial institutions are questionable assets with high associated capital charges. Each one alone would deserve a "junk" rating. Structured finance simply piles such risky assets into bundles and slices the bundles into tranches. The rating agencies deemed some 85% of the tranches by value as AAA, and nearly 99% as investment grade. [9] By their own admission the ratings companies have an inherent contradiction in their business model: they have a need to accomplish accurate ratings but they also have a need to gain and maintain market share. If their ratings came in consistently low (not AAA) for an issuer’s credit securities they would be in danger of losing that issuer as a customer. In other words, there is an inherent conflict of interest between bond issuers (who pay to get their issues rated) and the ratings agencies (who receive fees from the issuer to rate the issuers bonds). The problem was further exacerbated by the fact that the ratings agencies frequently had to evaluate an issue based on data provided by the issuer. The securitization process had become so complicated and opaque that the ratings agency had to rely on the issuer’s data. There was also the fact that the mortgage securitization process was so successful. As housing prices kept rising through the 1990’s into the 2000’s, mortgages rarely went into foreclosure and when they did their impact inside an MBS or CDO was mitigated thereby “proving” the ratings were accurate.


This system worked as long as housing prices increased. Systemic risk was ignored as more and more sub-prime and Alt A loans were securitized. The “triple A” securities were purchased by many diverse institutions with debt as if they were AAA bonds (they were, that is how they were rated). As long as the security’s mortgage interest cash flow was maintained this was a successful strategy but as more and more mortgages went into foreclosure, the value of the securities dropped requiring assets to be sold to maintain capital ratios while at the same time cash flows that paid the debt dropped, placing the owners of the securities close to or in default. It first hit Bear Stearns, then Lehmann Brothers

The housing bubble fueled by the success of the mortgage securitization process soon got another boost due to a major change in the leverage rules. At a key meeting of the SEC in 2004, at the request of the investment banking industry, debt to capital ratios were increased. Until then Investment Banks as well as regular banks were allowed to use 1 dollar of capital to borrow 10 dollars. Banks are still limited to 10 to 1. The decision allowed the brokerage entities of the largest investment banks (Bear Stearns, Lehmann Brothers, Merrill Lynch, Citicorp, Goldman Sachs) as well as many large hedge funds to use 1 dollar of capital to accumulate up to 40 dollars of debt. [11] At the end of 2007, Lehman Brothers was leveraged 31:1. Bear Stearns turned $1 into $33 through the magic of leverage. What this meant that was that with the advent of mark to market accounting (for a discussion of mark to market accounting see the following: [12]), on a mark to market basis, every bank with exposure to MBS, complex CDO and derivatives was prone to an amazing loss of value at staggering speeds. While the housing market bubble inflated (starting in the 1990’s, the investment banks and stock market participants valued portfolios of mortgage securities and other derivatives far greater than their book value. The mortgage backed securities process worked extremely as well as long as the underlying mortgages were primarily prime loans. The risk significantly increased in the early 2000s as sub-prime loans became the primary mortgage used in securitization. As the housing bubble deflated, many portfolios of these securities fell below book value. Since the big investment banks and large hedge funds were allowed to borrow excessively on the huge margin described in the previous paragraph, the drop in value due to mark to market accounting forced the investment banks to write down the value of the security or portfolio as a defensive measure against even greater losses. The rapid drop in value of securitized assets also forced margin calls as some hedge funds, for example, did not have sufficient additional collateral to protect against the margin call. Creditors who lent money to investment banks required certain margin and capital ratios and refused to extend additional credit to funds or investment banks as the value of their assets dwindled. This is what happened to Bear Stearns (it had to be taken over by JP Morgan with the assistance of the government) and to Lehmann Brothers (which was forced into bankruptcy). It’s also what forced Merrill Lynch to merge with Bank of America and Goldman Sachs and Citigroup to cease to exist as Investment Banks. The credit crisis dramatically collapsed the market cap values of many of the key players in the mortgage industry (whether they made risky loans or not) and in the investment banking community which had successfully securitized all forms of credit for so long. As the following table illustrates investors in these stockss lost over $1 trillion of market cap value (these stocks dropped 92% from their mid 2000 value) as a result of the mortgage securitization process based on securitizing risky loans and allowing excessive leverage to acquire such assets.

Mortgage Companies mid 2000s early 2009 Company Price Shares (millions) Mkt Cap millions Price Mkt Cap millions Fannie Mae $80.00 1000 $80,000 $0.40 $400 Freddie Mac $50.00 1400 $70,000 $0.17 $238 WAMU $45.00 1700 $76,500 $0.05 $85 Countrywide $52.00 580 $30,160 $6.00 $3,480 New Century $1,750 $55

Investment Bankers Goldman Sachs $240.00 460 $110,400 $100.00 $46,000 Bear Stearns $133.00 135 $17,955 $2.00 $270 Citigroup $52.00 5450 $283,400 $2.00 $10,900 Merrill Lynch $92.00 2000 $184,000 $6.00 $12,000 Lehmann Brothers $60.00 689 41,340 .04 27

Other Financial Institutions Bank of America $52.00 5000 $260,000 $6.00 $30,000 AIG $72.00 2500 $180,000 $0.35 $875

	 	 	$1,294,165	 	$104,303	 

Excellent summary reviews of this cycle of risky lending followed by securitization of sub-prime debt in conjunction with the use of excessive leverage can viewed in the CNBC documentary “House of Cards” [13] and the Wall Street Journal’s video series “The End of Wall Street”, January 2009 [14] .


The concept of subprime lending (providing loans to borrowers with low credit ratings or poor loan repayment histories) has been around for as long as lending has been around. Fannie Mae and Freddie Mac led mortgage industry in the 1990s facilitating home ownership by acquiring and insuring conforming loans. In the 90's congress directed the GSE's to lower the income requirement amongst lower income borrowers. The GSEs lowered the standards on the loans they acquired but they continued to only acquire prime or conforming loans. The commercial mortgage industry in order to keep loan volume up responed to this change by making more and more sub-prime loans. [15] For decades banks engaged in a practice called "redlining" or not loaning to anyone in a "low-income" neighborhood. Many believed this 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.[16]. As noted on the Wikipedia CRA page, the purpose of the act was to disallow the practice of "redlining" or denying loans to individuals who lived in certain neighborhoods (usually low income, minority neighborhoods). Some have believed the CRA encourage sub-prime lending. There is scant evidence this is the case. The CRA did not direct banks to make sub-prime lending but emphasized that loans should be made to those individuals who otherwise qualified but lived in low-income neighborhoods. The mortgage industry, however, did originally make a majority of their sub-prime loans in minority communities to individuals who had little or no experience with mortgage financing. This led to accusations of "predatory lending" by government housing authorities. [17] Lenders argued, however, that to account for lending to this higher risk group, they had to structure loans with higher interest rates to make up for their increase in risk. 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. [18]From 2004 to 2006, 21% of all mortgage originations were subprime, up from 9% from 1996 through 2004.[19] 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.[20][21] Sub-prime loans by themselves were not the prime mover of the 2008 Financial crisis. It was the securitization of these loans into supposedly AAA rated securities.

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.[22]

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.[23] 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.[24][25]

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.[26]

Structured Products Spread Subprime Debt Throughout the Financial System

In the aftermath of the savings and loans 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 credit rating (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.[27]

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).[28]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 2008. 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.[29]

On Friday, October 3rd 2008, the House of Representatives passed the amended version of the bill by a wide margin. The vote tally was:

House of Representatives Vote 10-03-08
Aye No Abstain

Within an hour of the Congressional passage of the act, it was signed into law by President George W. Bush.[30]

The Bailout Bill

Details of the proposal included:[31]

  • 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.
  • 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.

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.


The first bank to experience such a collapse was the UK based Northern Rock, which was nationalized in February 2008 [32] by the British government after failing to raise sufficient capital to meet its borrowing requirements. [33] 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.

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. [34] 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.[35]

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. [36] 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.[37]

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. [38] 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.

I see, I spupose that would have to be the case.


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.


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]


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. [44]

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. [45]

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. [46]

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. [47].

Retail Sales Retail sales are estimated to have declined by 2 to 3% for the 2008 holiday season relative to the previous year as a result of falling consumer spending, winter storms keeping shoppers away, and the effect of deep discounting. Retail sales figures will continue to fall as household budgets are constrained by lower disposable incomes. Not all retailers have been negatively affected – big box retailers have seen their sales increase as consumers look for lower prices, and the Used Goods Stores industry currently has quite low risk. Tax rate cuts to lower and middle income families should support the gradual recovery of household spending in the second half of 2009, and are expected to help turn the tide in retail sales later this year. [48]

Housing Starts The dramatic drop in housing starts since 2006 may have gone too far, with housing starts dropping to the lowest levels since records began by the end of 2008. A very moderate recovery is expected in the second half of 2009. (indicating a recession) in August 2000, seven months before the official beginning of the recession and five months after the burst of the dot.com bubble was reflected in stock markets. Though the recession did not officially end until November 2001, the index hit its trough in May of the year, before heading back above 50 in February 2002. Th "housing Starts" led to the mass liquidifaction process of ambiguity. the profit and loss esector of the high power banks.

The December 2008 reading of 32.4, the lowest since June 1980, may not be the lowest of the current business cycle as orders from Europe and Asia have stalled, forcing manufacturers to shed capacity and reduce inventories. However, it is probable that the trough will be reached in the first quarter of 2009, particularly as fiscal stimulus, both domestically and in China, will spur industrial production.[49]

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