"A situation in which the supply of money is outpaced by the demand for money. This means that liquidity is quickly evaporated because available money is withdrawn from banks (called a run), forcing banks either to sell other investments to make up for the shortfall or to collapse".
In broader terms "The term financial crisis is applied broadly to a variety of situations in which some financial institutions or assets suddenly lose a large part of their value. In the 19th and early 20th centuries, many financial crises were associated with banking panics, and many recessions coincided with these panics. Other situations that are often called financial crises include stock market crashes and the bursting of other financial bubbles, currency crises, and sovereign defaults"
Financial Crisis of 2007-09
Today's catastrophic financial and economic problems had their origins in a steep contraction in credit, full effect of which started to be felt in August 2007.However, the roots of the crisis can be traced further back, to the deflation of the high-tech bubble of a decade ago. When the stock markets began a steep decline in 2000 and the global economy started to slide into a recession, the United States Federal Reserve and other central banks sharply lowered interest rates to limit the economic damage. The sustained lower interest rates fuelled a
mortgage-borrowing boom, while also encouraging millions of homeowners to refinance their existing mortgages. Traditionally, banks had financed housing loans mainly through customer deposits, which had a limiting effect on the amount they could lend. In recent years, however, the financial industry had developed new business models that greatly expanded the funds available to increase mortgage lending dramatically. Mortgage lenders could immediately sell on to investment banks the home loans they made to borrowers, and the investment banks, in turn, would bundle thousands of such mortgages together, dice and slice them, and then sell them as "investment-grade" mortgage-backed securities
As the industry expanded rapidly, the quality of the mortgages it issued started to deteriorate, eventually turning sour when many homebuyers became over-leveraged. Not surprisingly, impairment rates exploded from 2006 without, however, a slowdown in the pace of lending. All the parties in the chain had become addicted to the high profits to be gained from churning out and selling these securities. Banks themselves had set up highly leveraged, off-balance-sheet, structured investment vehicles (SIVs) to buy and hold some of these
securities on their own account in order to maximize returns. Once the era of low interest rates ended, and many of the adjustable rate mortgages were reset higher, more and more borrowers started to default and the crisis began to snowball towards disaster. The following two factors triggered the financial crisis. The current financial crisis was triggered by the sub prime mortgage panic and by the widespread use of leveraged by the financial institutions to pump up their profits.
Causes of Financial Crisis
(01) Asset-liability mismatch
One of the main factors believed to contribute to financial crises is asset-liability mismatch, a situation in which the risks associated with an institution's debts and assets are not appropriately aligned. For example, commercial banks offer deposit accounts which can be withdrawn at any time and they use the proceeds to make long-term loans to businesses and homeowners. The mismatch between the banks' short-term liabilities (its deposits) and its long-term assets (its loans) is seen as one of the reasons bank runs occur which contributed to the financial crisis.
(02) Regulatory failures
According to the Managing Director of the IMF, Dominique Strauss-Kahn, has blamed the financial crisis of 2008 on 'regulatory failure to guard against excessive risk-taking in the financial system, especially in the US'. Likewise, the New York Times singled out the deregulation of credit default swaps as a cause of the crisis also the sub-prime mess, the huge risks taken by hedge funds, and the conflicts of interest that led to Enron, kindred scandals, are all the consequences of serial bouts of financial deregulation. Since the 1970s, in the name of free-market efficiency, Congress and presidents of both parties repealed key protections put in place by the New Deal. But the main effect has been to engineer windfall profits for financial insiders, replace real productive innovation with financial engineering, shift wealth from families to corporations, and put the entire American economy at ever greater risk. As a result, the economy has increasingly come to depend on asset bubbles -- overvalued stocks, overpriced real estate, and dubious financial instruments like derivatives. The bubbles have been pumped up by speculative borrowing. The borrowing feeds on itself, as it did in the 1920s, since an inflated asset is handy collateral for still more borrowing. Alarmingly, these bubbles turn out to be interconnected -- hedge-fund profits reliant on high-yield sub-prime mortgages, and a soaring stock market bid up by risky private equity deals -- so if the air goes out of one bubble, it goes out of others. That's why the crisis is so hard to manage, even by a very aggressive Federal Reserve.
(03) Fraud: Fraud has played a radical role in the collapse of some financial institutions, when companies have attracted depositors with misleading claims about their investment strategies, or have embezzled the resulting income. Examples include Charles Ponzi's scam in early 20th century Boston, the collapse of the giant investment corporations i.e. Enron and the fourth largest investment bank in USA Lehman Brothers and the collapse of Madoff Investment Securities in 2008.Many rogue traders that have caused large losses at financial institutions have been accused of acting fraudulently in order to hide their trades.
Fraud in mortgage financing has also been cited as one possible cause of the 2008 subprime mortgage crisis
(04) Monetary policy
According to the pundits of economy one reason for the recent economic slump was that the monetary policy focused only on traditional CPI, interest rates were kept low in spite of exploding prices of assets like real estate/property, credit assets, equity and commodities. And this was all made possible because of the huge current account surpluses in China and other EMEs, and huge private capital inflows into EMEs in excess of their current account deficit, getting recycled back as official capital flows into government bonds of reserve currency countries, especially the USA, resulting in compression of long term yields which, in turn, translated into lower long term interest rates even for the riskier asset. This chasing of yield, due to global savings surplus, in turn, led to a veritable credit bubble, characterized by unprecedented under pricing of risk as reflected in the all-time-low risk premium with junk bond spreads becoming indistinguishable from investment grade debt ! Such a low interest rate environment coupled with luxuriant supply of liquidity, created enabling environment for excessive leverage and risk taking so much so that American household debt exceeded enormously and which finally lead to the recent financial crisis.
(05) Over Optimism An important cause of the crisis are over-optimistic companies and individuals during the foregoing period of economic growth. They tend to believe that the general growth will continue forever without interrupting periods of economic decline. They also tend to overestimate themselves and think they will be a winner in the competition against other companies or persons, not a looser, not an average performer, but the winner.
This optimism, which is a general human property, makes all actors borrow massive amounts of capital and invest them in homes, luxury objects and expansion of their business which also played its role in the financial crisis
(06) Greed
I think one of the mammoth reasons for the financial crisis was the appetite for the profit because most of the corporations like the Lehman Brothers, Enron and some other real estate companies were desperately looking for a huge pool of profit and to capture extensive market share so these motives instigated them and, so they meet their destiny. So, I think we can sum up the cause of our current economic crisis in one word - GREED. Over the years, mortgage lenders were happy to lend money to people who couldn't afford their
mortgages. But they did it anyway because there was nothing to lose. These lenders were able to charge higher interest rates and make more money on sub-prime loans. If the borrowers default, they simply seized the house and put it back on the market. On top of that, they were able to pass the risk off to mortgage insurer or package these mortgages as mortgage-backed securities. Easy money!
Sectors affected by the Financial Crisis.
The recent financial crisis which was originated from the west have affect almost every sectors of the Economy, from household to the industrial sectors, But the most affected sectors are the following
(01) The Real Estate
The financial crisis which hit the USA and the European courtiers has profound affects on the real estate because it was one of the factors which triggered this catastrophic crisis because the American government encouraged the financial institutions to lend money to the middle class people of America. The following were the main affected companies in the real estate sector
Beazer Homes USA
Hovnanian Enterprises
Lennar Corporation
KB Home
NVR
Pulte Homes
Toll Brothers
(02) The financial institutions. It constitute of the following
The commercial banks
The investment banks
The non Banking Financial institutions i.e. the Insurance companies like AIG
The International Monetary Fund estimated that large U.S. and European banks lost more than $1 trillion on toxic assets and from bad loans from January 2007 to September 2009. These losses are expected to top $2.8 trillion from 2007-10. U.S. banks losses were forecast to hit $1 trillion and European bank losses will reach $1.6 trillion. The IMF estimated that U.S. banks were about 60 percent through their losses, but British and euro zone banks only 40 percent. One of the major sectors that were affected by the financial crisis was the banking sectors
In.The following financial institutions (including commercial banks and investment banks), building societies and insurance companies that have either been:
Taken over or merged with another financial institution;
nationalized by a government or central bank; or
Declared insolvent or liquidated.
The following are some of the prominent insurance companies that were declared insolvent or acquired.
Bear Stearns, New York City
Countrywide Financial, Calabasas, California
Fannie Mae and Freddie Mac
Merrill Lynch, New York City
Lehman Brothers, New York City
Washington Mutual, Seattle, Washington
Northern Rock (U.K bank)
Countrywide Financial Corp.
AIG (American International Group, Inc.)
(03) Effects on employment
The recent financial crisis which hit the world largest capitalist country USA, Had profound influence on the employment sectors
Due to the crisis the unemployment rate in the USA raised to 8.1% and especially on the employees of financial sectors jobs in financial services around the world have been strongly affected, with announced layoffs totaling 325,000 between August 2007 and 12 February 2009. These figures almost certainly understate the real situation, as announcements of job cuts are not always forthcoming. They are also unlikely to include layoffs from independent mortgage brokers, other independent contractors who provide subcontracting services to financial institutions, or the multitude of small financial firms who would not have
had the resources to weather the crisis and may have gone out of business entirely.
Impact on lower income countries
The global financial crisis is expected to have a major impact on low-income countries
(LICs), especially in sub-Saharan Africa-and urgent action is required by LIC policymakers and the international community. The crisis is projected to increase the financing needs of LICs by at least US$25 billion in 2009, and much larger needs are possible. Twenty-six LICs appear particularly vulnerable to the unfolding crisis. Additional external assistance and foreign financing will be essential to mitigate the impact of the crisis on LICs.
Impact of the current financial crisis on developing countries
The current financial crisis affects developing countries in two possible ways.
First, there could be financial contagion and spillovers for stock markets in emerging markets. The Russian stock market had to stop trading twice; the India stock market dropped by 8% in one day at the same time as stock markets in the USA and Brazil plunged. Stock markets across the world - developed and developing - have all dropped substantially since May 2008. We have seen share prices tumble between 12 and 19% in the USA, UK and Japan in just one week, while the MSCI emerging market index fell 23%. This includes stock markets in Brazil, South Africa, India and China..
Second, the economic downturn in developed countries may also have significant impact on developing countries. The channels of impact on developing countries include:
Impact of the current financial crisis on developed countries
The financial crises which take start from the west and than it become the global crisis. Most of the west countries are developed and is greatly affected by financial crisis. The economy of the developed countries are in decline. The market stability is destroyed and creates a lot of problems. Almost every sector of the economy is affected. The big organizations are liquidated or in survival stage. The example is Lehmon brothers which are liquidate due to financial crises.
What went wrong with the American polices.
The crisis has its roots in the U.S. government's efforts to increase homeownership, especially among minority and other underserved or low-income groups, and to do so through hidden financial subsidies rather than direct government expenditures. Expansion of homeownership could be a sound policy, especially for low-income families and members of minority groups. The social benefits of homeownership have been extensively documented, they include stable families and neighborhoods, reduced crime and delinquency, higher living standards, and less depreciation in the housing stock. Under these circumstances, the policy question is not whether homeownership should be encouraged but how the government ought to do it. In the United States, the policy has not been pursued directly--through taxpayer-supported programs and appropriated funds--but rather through manipulation of the credit system to force more lending in support of affordable housing. Instead of a direct government subsidy, say, for down-payment assistance for low-income families, the government has used regulatory and political pressure to force banks and other government-controlled or regulated private entities to make loans they would not otherwise make and to reduce lending standards so more applicants would have access to mortgage financing.
The two key examples of this policy are the CRA, adopted in 1977, and the affordable housing "mission" of the government-sponsored enterprises (GSEs)
Fannie Mae and Freddie Mac. As detailed below, beginning in the late 1980s--but particularly during the Clinton administration--the CRA was used to pressure banks into making loans they would not otherwise have made and to adopt looser lending standards that would make mortgage loans possible for individuals who could not meet the down payment and other standards that had previously been applied routinely by banks and other housing lenders. The same pressures were brought to bear on the GSEs, which adapted their underwriting standards so they could accept the loans made under the CRA and other loans that did not conform to what had previously been considered sound lending practices. Loans
to members of underserved groups did not come with labels, and once Fannie and Freddie began accepting loans with low down payments and other liberalized terms, the same unsound practices were extended to borrowers who could have qualified under the traditional underwriting standards. It should not be surprising that borrowers took advantage of these opportunities. It was entirely rational to negotiate for a low-down-payment loan when that permitted the purchase of a larger house in a better neighborhood.
The decline in underwriting standards is clear in the financial disclosures of Fannie and Freddie. From 2005 to 2007, Fannie and Freddie bought approximately $1 trillion in subprime and Alt-A loans, amounting to about 40 percent of their mortgage purchases during that period. Freddie's data show that it acquired 6 percent of its Alt-A loans in 2004; this jumped to 17 percent in 2005, 29 percent in 2006, and 32 percent in 2007. Fannie purchased 73 percent of its Alt-A loans during these three years. Similarly, in 2004, Freddie purchased 10 percent of the loans in its portfolio that had FICO scores of less than 620; it increased these purchases to 14 percent in 2005, 17 percent in 2006, and 30 percent in 2007, while Fannie purchased 57.5 percent of the loans in this category during the same period. For compliance with HUD's affordable-housing regulations, these loans tended to be "goal-rich." However, because they are now defaulting at unprecedented rates, the costs associated with these loans will be borne by U.S. taxpayers and are in large part the result of the failure of Congress to adopt an effective new regulatory structure for Fannie and Freddie. In this sense, the GSEs' extraordinary and devastating commitment to affordable housing loans was a tactical success. So due to the CRA (community Reinvestment Act) and relaxing the underwriting standards contributed to the financial crisis. Also there were serious flaws in the financial regulations, as the current financial meltdown makes clear, private financial markets do not always manage risk effectively on their own. In fact, to a large extent, the current crisis can be understood as the product of a profound failure in private risk management, combined with an equally profound failure in public risk management, particularly at the federal level.
Measures taken by US Government.
Since February 2008 the U.S. government has taken a number of steps aimed at dealing with the most severe financial crisis experienced by the United States in nearly eight decades. The crisis originated in America's real estate and banking industries and has now spread to the rest of the economy and to much of the world. Emergency legislation passed by the U.S. Congress in 2008 and early 2009 attempted to (1) prevent the failure of major U.S. financial institutions; (2) minimize the impact of financial institutions' weakness on ordinary business and
consumer borrowing; (3) provide immediate stimulus to consumer spending by raising after-tax household income through temporary tax reductions and increases in government transfers; (4) provide temporary funds to state and local governments in order to reduce their need to boost taxes or reduce spending during the recession; (5) protect the incomes and health insurance of newly laid off workers and members of other economically vulnerable populations; and (6) provide direct federal support for infrastructure investments and research and development projects in health, science, and efficient energy production.
Policy Response to The financial Crisis.
The current financial crisis which hit the USA and the European countries brought a crystal clear response in the US public polices and especially in the form of Reforms in the Financial Regulations here I am going to discuss some of the profound changes which US government brought in their Financial Regulations. According to this Reforms The plan would give new powers to the Federal Reserve -- the US central bank -- to oversee the entire financial system and create a new consumer protection agency to guard against the types of abuses that played a big role in the current crisis. Other reforms include the introduction of regulation for exotic derivatives
Such as credit default swaps, blamed for the near-collapse of America's biggest insurer, AIG. New rules will force mortgage companies to hang on to at least 5% of their loans rather than passing on all risk by bundling up products and securitising them on the secondary credit markets. The following are the main points of these reforms
• Federal Reserve would get powers to supervise big banks
• Hedge funds forced to register with watchdog
• Consumer body would stop 'predatory lending'
• Mortgage firms forced to keep loans in-house
The plan addresses many of the institutional lapses that created the current crisis the most sweeping change is empowering the Federal Reserve to be the systemic risk regulator, charged with identifying any firm whose combination of "size, leverage, and interconnectedness" qualifies it to be a "Tier 1 Financial Holding Company" -- essentially, a company that is too big to fail. These companies would be subject to more onerous capital and leverage requirements and closer government supervision. The Fed's role as systemic risk regulator
also touches on the proposed expansion of resolution authorities -- mechanisms for dismantling a failed bank. Under the administration's plan, the FDIC would gain authority to seize any failing financial institution -- an expansion beyond the deposit banks they currently take over -- and distribute their assets and debts appropriately. Ideally, the combination of the new requirements for the Tier 1 FHCs and the authority to break them up when they become insolvent will eliminate the false choice between an economically catastrophic failure and an expensive bailout for firms like American International Group. "The most important part of the plan for progressives is the creation of a Consumer Financial Protection Agency (CFPA), which would house all federal consumer financial regulation in one new office.
