Pavlenko A.S., scientific supervisor: Bogdanova V.S
Donetsk National University of Economics and Trade
named after M. Tugan-Baranjvsky
Global Financial Crisis Overview
The Global Financial crisis of 2007–2008 initially
referred to in the media as a "credit crunch" or "credit
crisis", began in August 2007, when a loss of confidence by investors in
the value of securitized mortgages in the United States resulted in a liquidity
crisis which prompted a substantial injection of capital into financial markets
by the United States Federal Reserve and the European Central Bank. The TED
spread, an indicator of perceived credit risk in the general economy, spiked up
in August 2007, remained volatile for a year, then spiked even higher in
September 2008.
Although America's housing collapse is often cited as
having caused the financial crisis, the financial system was vulnerable because
of intricate and overleveraged financial contracts and operations, the US
monetary policy making the cost of credit negligible therefore encouraging such
over-leverage, and generally a hypertrophy of the financial sphere.
One example was credit derivatives - Credit Default
Swaps (CDS), which insure debt holders against default. They are fashioned
privately, traded over the counter outside the purview of regulators. The U.S.
government's seizure of the mortgage companies prompted an auction of their
debt so that traders who bought and sold default protection (CDS) could settle
contracts. The auctions are used to set a price by which investors can settle
the contracts with cash rather than having to physically deliver a bond to
their counterparties. Sellers of protection pay the face value of the contracts
minus the recovery value set on the bonds.
After
affecting banking and credit, mainly in the USA, the financial crisis evolved
into a global general financial crisis verging on a systemic crisis. Mechanical
phenomena such as domino effect, and also psychological contagions, made it
spread at the same time worldwide and into many financial and economic areas
including:
- Financial
markets, stock exchanges and derivative markets in particular, where it
developed into a market crash.
- Various
equity funds and hedge funds that went short of cash and had to get rid of
assets.
- Insurance
activities and pension funds, facing a receding asset portfolio value to cover
their commitments,
- Impact on
public finance due to the bailout actions.
- Forex, at
least for some currencies including Icelandic crown, various Eastern Europe and
Latin American currencies.
The initial liquidity crisis can in hindsight be seen
to have resulted from the incipient subprime mortgage crisis. One of the first
victims outside the US was Northern Rock, a major British bank. The bank's
inability to borrow additional funds to pay off maturing debt obligations led
to a bank run in mid-September 2007. The highly leveraged nature of its
business, unsupportable without fresh infusions of cash, led to its takeover by
the British Government and provided an early indication of the troubles that
would soon befall other banks and financial institutions.
Excessive
lending under loosened underwriting standards, which was a hallmark of the
United States housing bubble, resulted in a very large number of subprime
mortgages. These high-risk loans had been perceived to be mitigated by
securitization. Rather than mitigating the risk, however, this strategy appears
to have had the effect of broadcasting and amplifying the crisis in a domino
effect. The damage from these failing securitization schemes eventually cut
across a large swath of the housing market and the housing business and led to
the subprime mortgage crisis. The accelerating rate of foreclosures caused an
ever greater number of homes to be dumped onto the market. This glut of homes
decreased the value of other surrounding homes which themselves became subject
to foreclosure or abandonment. The resulting spiral underlay a developing
financial and economic crisis.
Beginning
with bankruptcy of Lehman Brothers on September 14, 2008, the financial crisis
entered an acute phase marked by failures of prominent American and European
banks and efforts by the American and European governments to rescue distressed
financial institutions, in the United States by passage of the Emergency
Economic Stabilization Act of 2008 and in European countries by infusion of
capital into major banks. Afterwards, Iceland almost reached a point of
bankruptcy. Many financial institutions in Europe also faced the liquidity
problem that they needed to raise their capital adequacy ratio. As the
financial crisis developed, stock markets fell worldwide, and global financial
regulators attempted to coordinate efforts to contain the financial crisis.
The US government threw the $700 billion plan which
was attempted to purchase the underperforming collaterals and assets. However,
the plan was vetoed by the US congress because some members rejected the idea
that the taxpayers’ money will be used to bail out the Wall Street's investment
bankers. The stock market plunged as a result - the US congress amended the
$700 billion bail-out plan and finally passed the legislation. Unfortunately,
the market sentiment continuously deteriorated and the global financial system
almost collapsed.
While the market turned extremely pessimistic, the
British government launched a 500 billion pounds bail-out plan aimed to
injecting capital into the financial system. The British government
nationalized most of the financial institutions in trouble. Many European
governments followed as well as the US government. Stock markets appeared to
have stabilized by the end of October. In addition, the falling prices due to
reduced demand for oil, coupled with projections of a global recession, brought
the 2000s energy crisis to temporary resolution. In the Eastern European
economies of Poland, Hungary, Romania, and Ukraine the economic crisis was
characterized by difficulties with loans made in hard currencies such as the
Swiss franc. As local currencies in those countries lost value making payment
on such loans became progressively difficult.
A number of commentators have suggested that if the
liquidity crisis continues, there could be an extended recession or worse. The
continuing development of the economic crisis prompted fears of a global
economic collapse. The financial crisis is likely to yield the biggest banking
shakeout since the savings-and-loan meltdown. Investment bank UBS stated on
October 6 that 2009 would see a clear global recession, with recovery unlikely
for at least two years. Three days later UBS economists announced that the
"beginning of the end" of the crisis had begun, with the world
starting to make the necessary actions to fix the financial and economic
crisis: capital injection by governments; injection made systemically; interest
rate cuts to help borrowers. The United Kingdom had started systemic injection,
and the world's central banks were now cutting interest rates. UBS emphasized
the United States needed to implement systemic injection. UBS further
emphasized that this fixes only the financial crisis, but that in economic
terms "the worst is still to come". UBS quantified their expected
recession durations on October 16: two quarters for the Eurozone, three quarters
for the United States, and four quarters for the United Kingdom.
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