Question

Based on all the information you could search and obtain, please show your personal understandings for the following questions regarding the 2008 financial crisis:

(1) What were the problems in our economy during the pre-crisis period, which finally led the entire world into this unprecedented crisis? Could you explain why those problems had such a severe impact to our economy?

(2) Could you please show at least two financial tools that were heavily used by Wall Street before 2008 but finally magnified our losses during the crisis? (For example, CDOs, CDS, and etc.) Please illustrate the basic idea of these tools (how did they work and being traded, what are the entities get involved in these tools, and etc.) and also why these tools lead the market into a severe collapse.

(3) Based on your own understanding, why the initial collapse of US markets finally generates a contagious effect to other countries, that other countries also suffer a lot and experienced severe local market collapses (For example, the post-2008 European sovereign debt crisis).

(4) What are the measures you think would be useful for us (as individuals, firms, local governments, and global organizations respectively) to deal with the financial crisis, and help us forecast the crisis and reduce the cost of it. And why?

Answer 1

1) Problems in economy before 2008 crisis -

Like all previous cycles of booms and busts, the seeds of the subprime meltdown were sown during unusual times. In 2001, the U.S. economy experienced a mild, short-lived recession. Although the economy nicely withstood terrorist attacks, the bust of the dot-com bubble and accounting scandals(Enron accounting scam), the fear of recession really preoccupied everybody's minds.

There were early signs of distress: by 2004, U.S. homeownership had peaked at 70%; no one was interested in buying or eating more candy. Then, during the last quarter of 2005, home prices started to fall, which led to a 40% decline in the U.S. Home Construction Index during 2006. Not only were new homes being affected, but many subprime borrowers now could not withstand the higher interest rates and they started defaulting on their loans.

This caused 2007 to start with bad news from multiple sources. Every month, one subprime lender or another was filing for bankruptcy. During February and March 2007, more than 25 subprime lenders filed for bankruptcy, which was enough to start the tide. In April, well-known New Century Financial also filed for bankruptcy.

It became apparent in August 2007 that the financial market could not solve the subprime crisis on its own and the problems spread beyond the UnitedState's borders. The interbank market froze completely, largely due to prevailing fear of the unknown amidst banks. Northern Rock, a British bank, had to approach the Bank of England for emergency funding due to a liquidity problem. By that time, central banks and governments around the world had started coming together to prevent further financial catastrophe.

Multidimensional Problems

The subprime crisis's unique issues called for both conventional and unconventional methods, which were employed by governments worldwide. In a unanimous move, central banks of several countries resorted to coordinated action to provide liquidity support to financial institutions. The idea was to put the interbank market back on its feet.

The Fed started slashing the discount rate as well as the funds rate, but bad news continued to pour in from all sides. Lehman Brothers filed for bankruptcy, Indymac bank collapsed, Bear Stearns was acquired by JP Morgan Chase (NYSE: JPM), Merrill Lynch was sold to Bank of America and Fannie Mae and Freddie Mac were put under the control of the U.S. federal government.

By October 2008, the Federal funds rate and the discount rate were reduced to 1% and 1.75%, respectively. Central banks in England, China, Canada, Sweden, Switzerland and the European Central Bank (ECB) also resorted to rate cuts to aid the world economy. But rate cuts and liquidity support in itself were not enough to stop such a widespread financial meltdown.

The U.S. government then came out with National Economic Stabilization Act of 2008, which created a corpus of $700 billion to purchase distressed assets, especially mortgage-backed securities. Different governments came out with their versions of bailout packages, government guarantees and outright nationalization.

Impact on economy

Back in 2006, when the US housing market started to collapse and prices fell tremendously, consequences for the economy as well as for US citizens had been severe. Unable to serve their mortgages, people had to leave their homes for sale. Foreclosure of houses reached 6 million until 2010. But not only people had to leave their homes, it was also the building industry and the real estate sector facing hard times as there was no longer enough demand after the bubble busted. Soon the first mortgage lending companies were sliding into bankruptcy and the subprime mortgage crisis turned into a financial crisis.

2) Probably the most severe consequences of the collapsing housing market and financial crisis had to face investors. Not only investment firms and hedgefonds manager made huge losses when their collateralized debt obligations and mortgage backed securities defaulted, there were also smaller institutions and private investors who placed their money in collateralized debt obligation (CDO) to profit from interest earnings. Especially retirement funds and public employee pensions, who invested in the most secure tranche of a CDO, almost lost all of their money.

The bankers thought that it just wasn't enough to lend the candies lying on their shelves. They decided to repackage candy loans into collateralized debt obligations (CDOs) and pass on the debt to another candy shop. Hurrah! Soon a big secondary market for originating and distributing subprime loans developed. To make things merrier, in October 2004, the Securities Exchange Commission (SEC) relaxed the net capital requirement for five investment banks - Goldman Sachs (NYSE:GS), Merrill Lynch (NYSE:MER), Lehman Brothers, Bear Stearns and Morgan Stanley (NYSE:MS) - which freed them to leverage up to 30-times or even 40-times their initial investment. Everybody was on a sugar high, feeling as if the cavities were never going to come.

3) As the financial downturn in the US continues irresistibly, the recession now starts to spread globally. The world economy is nowadays linked together so close and interactions between companies, investors and banks increased heavily the last decades. In late 2008 the world stock market reacts to the crisis with a tremendous fall. In Europe several subsidiaries and offices of the banking companies had to close and banks in Germany for example had to be rescued by the government as they also invested heavily in American real estate securities. 15 Consumers around the world consume less and spend less because they either lost money or feared to lose their jobs in an insecure development.

As a consequence of that, exports especially in the US collapsed, which affected suppliers from China and Japan. Highly dependent from the US market, Chinese manufacturers faced problems as their major markets stopped to invest and reduced demand. Only in China more than 10 million migrant workers lost their jobs.16 In the meantime, unemployment’s rates in the US also “shot up to 7.2% in December from its recent low of 4.4% in March 2007, and it was almost certain to continue rising into 2009.”17 Later at the end of the crisis unemployment rates both in the US and Europe should be risen to 10%, the highest value since the 70’s. The recession had reached almost every sector of the world economy. Even world leading firms like G.M and Chrysler who employ together more than 280.000 people were facing bankruptcy and also had to be rescued by government funds.

4) Measures to prevent financial crisis:

Hundreds of billions of dollars are essentially being wasted, languishing as liquid assets, because of counterproductive liquidity-requirement regulations resulting from the mischaracterization of the crisis, he says.

So Thakor, a member of the European Corporate Governance Institute, recommends specific pre-emptive and post-crisis measures to replace standards or accentuate the Third Basel Accord, or Basel III, regulatory framework for banks:

• Increase capital requirements for shadow banks and depository institutions and make them countercyclical.
• Eliminate liquidity requirements.
• Improve consumer literacy and restrict consumer leverage.
• Create a Chapter 11 bankruptcy for banks.
• Design a more integrated regulatory structure.
• Focus on bank governance and culture.

And, in response to issues:

• Temporarily resolve a financial crisis by imposing dividend restrictions and by providing government capital support that dilutes shareholders.
• Enforce greater consequences on executives of failing banks.