The termA financial crisisA is applied to a variety of situations in which some financial institutions suddenly lose a large part of their value of assets. A financial crisis is generally known as Recession. In the 19th and early 20th centuries, many financial crises were associated withA banking panics, and manyA recessionsA coincided with these panics. Other situations that are often called financial crises includeA stock market crashesA and the bursting of other financialA bubbles,A currency crises, andA sovereign defaults.A Financial crises directly result in a loss ofA paper wealth; they do not directly result in changes in the real economy unless a recession or depression follows. Many economists have offered theories about how financial crises develop and how they could be prevented.
There is little consensus, however, and financial crises are still a regular occurrence around the world. AA recessionA is aA business cycleA contraction, a general slowdown in economic activity over two consecutive quarters in a year.A During recessions, many macroeconomicA indicators vary in a similar way. Recession is measured by GDP as a fall in GDP or negative GDP is considered to be Recession. Production as measured byA Gross Domestic ProductA (GDP), employment, investment spending,A capacity utilization, household incomes, business profits andA inflationA all fall during recessions; whileA bankruptciesA and theA unemployment rateA rise. Recessions are generally believed to be caused by a widespread drop in spending. Governments usually respond to recessions by adopting expansionary macroeconomic policies, such asA increasing money supply, increasing subsidies,A increasing government spending and decreasing taxation. In theA United States, the Business Cycle Dating Committee of theA National Bureau of Economic ResearchA (NBER) is generally seen as the authority for dating US recessions.
The NBER defines an economic recession as: “a significant decline in [the] economic activity spread across the country, lasting more than a few months, normally visible inA realA GDPA growth, real personal income, employment (non-farm payrolls), industrial production, and wholesale-retail sales.”A Almost universally, academics, economists, policy makers, and businesses defer to the determination by the NBER for the precise dating of a recession’s onset and end. History: Financial Crisis A noted survey of financial crises isA This Time is Different: Eight Centuries of Financial FollyA (Reinhart HYPERLINK “https://en.wikipedia.org/wiki/Financial_crisis#CITEREFReinhartRogoff2009″&HYPERLINK “https://en.wikipedia.org/wiki/Financial_crisis#CITEREFReinhartRogoff2009” Rogoff 2009), by economistsA Carmen ReinhartA andA Kenneth Rogoff, who are regarded as among the foremost historians of financial crises.A In this survey, they trace the history of financial crisis back toA sovereign defaultsA – default onA publicA debt, – which were the form of crisis prior to the 18th century and continue, then and now causing private bank failures; crises since the 18th century feature both public debt default and private debt default.
Reinhart and Rogoff also classA debasementA of currency andA hyperinflationA as being forms of financial crisis, broadly speaking, because they lead to unilateral reduction (repudiation) of debt. 19th century Danish state bankruptcy of 1813 Panic of 1819A – pervasive USA economic recession w/ bank failures; culmination of U.S.’s 1st boom-to-bust economic cycle Panic of 1825A – pervasive British economic recession in which many British banks failed, & Bank of England nearly failed Panic of 1837A – pervasive USA economic recession w/ bank failures; a 5 yrA depressionA ensued Panic of 1847A – a collapse of British financial markets associated with the end of the 1840sA railroadA boom. Panic of 1857A – pervasive USA economic recession w/ bank failures 1866:A Overend Gurney crisisA – comprised theA Panic of 1866A (primarily British) Panic of 1873A – pervasive USA economic recession w/ bank failures, known then as the 5 yrA Great DepressionA & now as theA Long Depression Panic of 1884 Panic of 1890 Panic of 1893A – a panic in the United States marked by the collapse of railroad overbuilding and shaky railroad financing which set off a series of bank failures Australian banking crisis of 1893 Panic of 1896A – an acuteA economic depressionA in theA United StatesA precipitated by a drop inA silver reservesA and market concerns on the effects it would have on thegold standard 20th century Panic of 1901A – limited to crashing of the New York Stock Exchange Panic of 1907A – pervasive USA economic recession w/ bank failures Panic of 1910-1911 1910 -A Shanghai rubber stock market crisis Wall Street Crash of 1929, followed by theA Great DepressionA – the largest and most important economic depression in the 20th century 1973 -A 1973 oil crisisA – oil prices soared, causing theA 1973-1974 stock market crash Secondary banking crisis of 1973-1975A – United Kingdom 1980s -A Latin American debt crisisA – beginning in Mexico in 1982 with theA Mexican Weekend Bank stock crisis (Israel 1983) 1987 -A Black Monday (1987)A – the largest one-day percentage decline in stock market history 1989-91 -A United States Savings HYPERLINK “https://en.wikipedia.org/wiki/Savings_and_loan_crisis”&HYPERLINK “https://en.wikipedia.org/wiki/Savings_and_loan_crisis” Loan crisis 1990 -A Japanese asset price bubbleA collapsed early 1990s – Scandinavian banking crisis:A Swedish banking crisis,A Finnish banking crisis of 1990s 1992-93 -A Black WednesdayA – speculative attacks on currencies in theA European Exchange Rate Mechanism 1994-95 -A 1994 economic crisis in MexicoA – speculative attack and default on Mexican debt 1997-98 -A 1997 Asian Financial CrisisA – devaluations and banking crises across Asia 1998 Russian financial crisis 21st century 2001 – Bursting ofA dot-com bubbleA – speculations concerning internet companies crashed 2007-10 -A Financial crisis of 2007-2010, followed by theA late 2000s recessionA and theA 2010 European sovereign debt crisis. Brief intro of Lehman Brothers Lehman Brothers: The I one to be affected Lehman Brothers Holdings Inc. was a global financial services firm which, until declaring bankruptcy in 2008, participated in business in investment banking, equity and fixed-income sales, research and trading, investment management, private equity, and private banking. It was a primary dealer in the U.S. Treasury securities market. Its primary subsidiaries included Lehman Brothers Inc., Neuberger Berman Inc., Aurora Loan Services, Inc., SIB Mortgage Corporation, Lehman Brothers Bank, FSB, Eagle Energy Partners, and the Crossroads Group.
The firm’s worldwide headquarters were in New York City, with regional headquarters in London and Tokyo, as well as offices located throughout the world. On September 15, 2008, the firm filed for Chapter 11 bankruptcy protection following the massive exodus of most of its clients, drastic losses in its stock, and devaluation of its assets by credit rating agencies. The filing marked the largest bankruptcy in U.S. history. The following day, Barclays announced its agreement to purchase, subject to regulatory approval, Lehman’s North American investment-banking and trading divisions along with its New York headquarters building. On September 20, 2008, a revised version of that agreement was approved by U.S. Bankruptcy Judge James M. Peck. During the week of September 22, 2008, Nomura Holdings announced that it would acquire Lehman Brothers’ franchise in the Asia Pacific region, including Japan, Hong Kong and Australia. as well as, Lehman Brothers’ investment banking and equities businesses in Europe and the Middle East. The deal became effective on 13 October 2008. Lehman Brothers’ investment management business, including Neuberger Berman, was sold to its management on December 3, 2008. Creditors of Lehman Brothers Holdings Inc. retain a 49% common equity interest in the firm, now known as Neuberger Berman Group LLC. It is the fourth largest private employee-controlled asset management firm globally, behind Fidelity Investments, The Capital Group Companies and Wellington Management Company. A March 2010 report by the court-appointed examiner indicated that Lehman executives regularly used cosmetic accounting gimmicks at the end of each quarter to make its finances appear less shaky than they really were.
This practice was a type of repurchase agreement that temporarily removed securities from the company’s balance sheet. However, unlike typical repurchase agreements, these deals were described by Lehman as the outright sale of securities and created “a materially misleading picture of the firm’s financial condition in late 2007 and 2008.” Causes of Collapse
In August 2007, the firm closed its subprime lender, BNC Mortgage, eliminating 1,200 positions in 23 locations, and took an after-tax charge of $25 million and a $27 million reduction in goodwill. Lehman said that poor market conditions in the mortgage space “necessitated a substantial reduction in its resources and capacity in the subprime space”. In 2008, Lehman faced an unprecedented loss to the continuing subprime mortgage crisis. Lehman’s loss was a result of having held on to large positions in subprime and other lower-rated mortgage tranches when securitizing the underlying mortgages; whether Lehman did this because it was simply unable to sell the lower-rated bonds, or made a conscious decision to hold them, is unclear. In any event, huge losses accrued in lower-rated mortgage-backed securities throughout 2008. In the second fiscal quarter, Lehman reported losses of $2.8 billion and was forced to sell off $6 billion in assets. In the first half of 2008 alone, Lehman stock lost 73% of its value as the credit market continued to tighten. In August 2008, Lehman reported that it intended to release 6% of its work force, 1,500 people, just ahead of its third-quarter-reporting deadline in September. On August 22, 2008, shares in Lehman closed up 5% (16% for the week) on reports that the state-controlled Korea Development Bank was considering buying the bank.
Most of those gains were quickly eroded as news came in that Korea Development Bank was “facing difficulties pleasing regulators and attracting partners for the deal.” It culminated on September 9, when Lehman’s shares plunged 45% to $7.79, after it was reported that the state-run South Korean firm had put talks on hold. On September 17, 2008 Swiss Re estimates its overall net exposure to Lehman Brothers as approximately CHF 50 million. Investor confidence continued to erode as Lehman’s stock lost roughly half its value and pushed the SHYPERLINK “https://en.wikipedia.org/wiki/S&P_500″&HYPERLINK “https://en.wikipedia.org/wiki/S&P_500″P 500 down 3.4% on September 9. The Dow Jones lost 300 points the same day on investors’ concerns about the security of the bank. The U.S. government did not announce any plans to assist with any possible financial crisis that emerged at Lehman. The next day, Lehman announced a loss of $3.9 billion and their intent to sell off a majority stake in their investment-management business, which includes Neuberger Berman. The stock slid seven percent that day.
Lehman, after earlier rejecting questions on the sale of the company, was reportedly searching for a buyer as its stock price dropped another 40 percent on September 11, 2008. Just before the collapse of Lehman Brothers, executives at Neuberger Berman sent e-mail memos suggesting, among other things, that the Lehman Brothers’ top people forgo multi-million dollar bonuses to “send a strong message to both employees and investors that management is not shirking accountability for recent performance.” Lehman Brothers Investment Management Director George Herbert Walker IV dismissed the proposal, going so far as to actually apologize to other members of the Lehman Brothers executive committee for the idea of bonus reduction having been suggested. He wrote, “Sorry team. I am not sure what’s in the water at Neuberger Berman. I’m embarrassed and I apologize.”
During hearings on the bankruptcy filing by Lehman Brothers and bailout of AIG before the House Committee on Oversight and Government Reform, former Lehman Brothers CEO Richard Fuld said a host of factors including a crisis of confidence and naked short-selling attacks followed by false rumors contributed to both the collapse of Bear Stearns and Lehman Brothers. House committee Chairman Henry Waxman said the committee received thousands of pages of internal documents from Lehman and these documents portray a company in which there was “no accountability for failure”. An article by journalist Matt Taibbi in Rolling Stone contended that naked short selling contributed to the demise of both Lehman and Bear Stearns. A study by finance researchers at the University of Oklahoma Price College of Business studied trading in financial stocks, including Lehman Brothers and Bear Stearns, and found “no evidence that stock price declines were caused by naked short selling.”. Causes of Financial Crisis Strategic complementarities in financial markets It is often observed that successful investment requires each investor in a financial market to guess what other investors will do.A George SorosA has called this need to guess the intentions of others ‘reflexivity’.A Similarly,A John Maynard KeynesA compared financial markets to aA beauty contest gameA in which each participant tries to predict which modelA otherA participants will consider most beautiful. Furthermore, in many cases investors have incentives toA coordinateA their choices.
For example, someone who thinks other investors want to buy lots ofA Japanese yenA may expect the yen to rise in value, and therefore has an incentive to buy yen too. Likewise, a depositor inA IndyMac BankA who expects other depositors to withdraw their funds may expect the bank to fail, and therefore has an incentive to withdraw too. Economists call an incentive to mimic the strategies of othersA strategic complementarily. It has been argued that if people or firms have a sufficiently strong incentive to do the same thing they expect others to do, thenA self-fulfilling propheciesA may occur.A For example, if investors expect the value of the yen to rise, this may cause its value to rise; if depositors expect a bank to fail this may cause it to fail.A Therefore, financial crises are sometimes viewed as aA vicious circleA in which investors shun some institution or asset because they expect others to do so.[ Leverage Leverage, which means borrowing to finance investments, is frequently cited as a contributor to financial crises.it borrows in order to invest more, it can potentially earn more from its investment, but it can also lose more than all it has. Therefore leverage magnifies the potential returns from investment, but also creates a risk ofA bankruptcy. Since bankruptcy means that a firm fails to honor all its promised payments to other firms, it may spread financial troubles from one firm to another The average degree of leverage in the economy often rises prior to a financial crisis.
For example, borrowing to finance investment in theA stock marketA (“margin buying”) became increasingly common prior to theA Wall Street Crash of 1929. Asset-liability mismatch Another factor believed to contribute to financial crises isA 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 reasonsA bank runsA occur (when depositors panic and decide to withdraw their funds more quickly than the bank can get back the proceeds of its loans)A Likewise,A Bear StearnsA failed in 2007-08 because it was unable to renew the short-term debt it used to finance long-term investments in mortgage securities. In an international context, many emerging market governments are unable to sell bonds denominated in their own currencies, and therefore sell bonds denominated in US dollars instead. This generates a mismatch between the currency denomination of their liabilities (their bonds) and their assets (their local tax revenues), so that they run a risk ofA sovereign defaultA due to fluctuations in exchange rates. Uncertainty and herd behavior Many analyses of financial crises emphasize the role of investment mistakes caused by lack of knowledge or the imperfections of human reasoning.A Behavioral financeA studies errors in economic and quantitative reasoning. Psychologist Torbjorn K A Eliazonhas also analyzed failures of economic reasoning in his concept of ‘A…“copathy’. Historians, notablyA Charles P. Kindleberger, have pointed out that crises often follow soon after major financial or technical innovations that present investors with new types of financial opportunities, which he called “displacements” of investors’ expectationsA Early examples include theA South Sea BubbleA andA Mississippi BubbleA of 1720, which occurred when the notion of investment in shares of companyA stockA was itself new and unfamiliar,A and theA Crash of 1929, which followed the introduction of new electrical and transportation technologies.A More recently, many financial crises followed changes in the investment environment brought about by financial deregulation, and the crash of theA dot com bubbleA in 2001 arguably began with “irrational exuberance” about Internet technology.
Unfamiliarity with recent technical andA financial innovationsA may help explain how investors sometimes grossly overestimate asset values. Also, if the first investors in a new class of assets (for example, stock in “dot com” companies) profit from rising asset values as other investors learn about the innovation (in our example, as others learn about the potential of the Internet), then still more others may follow their example, driving the price even higher as they rush to buy in hopes of similar profits. If such “herd behavior” causes prices to spiral up far above the true value of the assets, a crash may become inevitable. If for any reason the price briefly falls, so that investors realize that further gains are not assured, then the spiral may go into reverse, with price decreases causing a rush of sales, reinforcing the decrease in prices. Regulatory failures Governments have attempted to eliminate or mitigate financial crises by regulating the financial sector. One major goal of regulation isA transparency: making institutions’ financial situations publicly known by requiring regular reporting under standardized accounting procedures. Another goal of regulation is making sure institutions have sufficient assets to meet their contractual obligations, through reserve,A capital requirements, and other limits onA leverage.
Some financial crises have been blamed on insufficient regulation, and have led to changes in regulation in order to avoid a repeat. For example, the Managing Director of theA IMF,A 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’.A Likewise, the New York Times singled out the deregulation ofA credit default swapsA as a cause of the crisis. However, excessive regulation has also been cited as a possible cause of financial crises. In particular, theA Basel II AccordA has been criticized for requiring banks to increase their capital when risks rise, which might cause them to decrease lending precisely when capital is scarce, potentially aggravating a financial crisis. Fraud Fraud has played a role in the collapse of some financial institutions, when companies have attracted depositors with misleading claims about their investment strategies, or haveA embezzledA the resulting income.
Examples includeA Charles Ponzi’s scam in early 20th century Boston, the collapse of theA MMMA investment fund in Russia in 1994, the scams that led to theA Albanian Lottery Uprisingof 1997, and the collapse ofA Madoff Investment SecuritiesA in 2008. ManyA rogue tradersA 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 2008A subprime mortgage crisis; government officials stated on September 23, 2008 that theA FBIA was looking into possible fraud by mortgage financing companiesA Fannie MaeA and Freddie Mac,A Lehman Brothers, and insurerA American International Group Contagion ContagionA refers to the idea that financial crises may spread from one institution to another, as when ban run spreads from a few banks to many others, or from one country to another, as when currency crises, sovereign defaults, or stock a market crashes spread across countries. When the failure of one particular financial institution threatens the stability of many other institutions, this is calledA systemic risk One widely-cited example of contagion was the spread of theA Thai crisis in 1997A to other countries likeA South Korea. However, economists often debate whether observing crises in many countries around the same time is truly caused by contagion from one market to another, or whether it is instead caused by similar underlying problems that would have affected each country individually even in the absence of international linkages. Recessionary effects Some financial crises have little effect outside of the financial sector, like theA Wall Street crash of 1987, but other crises are believed to have played a role in decreasing growth in the rest of the economy.
There are many theories why a financial crisis could have a recessionary effect on the rest of the economy. These theoretical ideas include the ‘financial accelerator’, ‘flight to quality’ and ‘flight to liquidity’, and theA Kiyotaki-Moore model.
SomeA ‘HYPERLINK “https://en.wikipedia.org/wiki/Currency_crisis#Theories_of_currency_crises”third generationHYPERLINK “https://en.wikipedia.org/wiki/Currency_crisis#Theories_of_currency_crises”‘HYPERLINK “https://en.wikipedia.org/wiki/Currency_crisis#Theories_of_currency_crises” models of currency crisesA explore how currency crises and banking crises together can cause recessions. Time line given by World Bank Interactive financial crisis timeline Story of the unfolding financial crisis and the bank’s response -sept2007 # oil rises $133 per barrel # several countries suffer shortage and malnutrition due to export bans and rise in prises -march 2008(harsh new reality) #36 countries are in crisis as a result of higher food prices and will require external assistance # the root cause of the phenomenon of rising food price – higher energy and fertilizer prices, the demand for the food crops in bio fuel production and low food stocks – are likely to prevail in the medium turn, says the bank. -april 2008 (early investment to fight hunger ) # world bank calls for plan to fight hunger pledge to double agricultural investment in African to $ 800 million -may2008 (response initiatives # $ 1.2 billion global food prices response programme (GFRP) launches to provide relief to countries hard hit by food high prices in april 2009,GFRP increased to $2 billion. -august 2008( crises spreads) #US treasury intervenes in growing financial turmoil #crises spreads rapidly through financial sector of advanced economies. # major banks draw back on financing for trade and foreign investment # Crises beguns to hit emerging economies -Octuber 2008 (Food full and financial crisis) # developing countries face triple hit from food, fule and financial crisis, adding that the number of malnourished people globally will grow by 44 million to 967 million in 2008. # at the bank fund 2008 annual meetings, the bank wants the financial bail out must include developing countries as well. Dec. 2008(Slowing growth and diminishing wealth) # GDP and job losses surge across high income countries. # Oil drops to $ 41 per Barrel in dec. 2008 # 24 of 26 middle income countries experience GDP decline. # Bank begins to fast track assistance to hard hit countries. World bank Group launches facilities to boost microfinance infrastructure & bank recapitalization.
Jan 2009 (the vulnerability fund) # The Bank calls for developed countries to pledge the equivalent of 0.7 % of their stimulus packages, or as much as they can in additional money to help developing countries which can not afford bail outs and deficits. Feb 2009 (Conditional cash transfers) # the bank expands conditional cash transfer progremes to $ 2.4 billion. Such programs offer qualifying families money in exchange for commitment such as taking babies to health clinics and keeping children in school. March 2009 (Global output contracts) # according to latest bank economic forcast first decline in global output since world war II is expected in 2009 as global GDP is set to contract by 17% April 2009 # stregthining protection, infrastructure on a track # The bank triples its investment in safety nets and other social protection programmes in health and education to $12 billion over next 2 years to protect the most vulnerable people from the worst effects of the global economic crises. # The bank creates a $ 45 billion facility for infrastructure investment over the next 3 years to help create jobs. # Speed crises recovery and ensure long term development the bank is also boosting overall agriculture landing to $ 12 billion over the next 2 years -june 2009 ( boosting rural finance, more help needed for poor, charting a global recovery) # the bank establishes the agriculture finance support facility to expanf=d rural finance through a $ 20 million bill and melinda Gates foundation contribution. The facility will increase growers acces to financial services , such as saving credit payments and insurance. # World economy will decline this year by close to 3% percent, more than previsouly estimated. # Poor countries will continue to be hit hard by multiple waves of economic stress. # World sees drop in global output trade and private capital flows. # Indicator of a deepening recession inform the Bank’s push for concerted global action wile crisis is still underway.
July 2009 (Record assistance to crisis hit countries) # The bank Group committed nearly $60 billion in 2009 to help countries struggling aimed the global economic crisis. August 2009 (continued price rise) # Oil back up to $ 70 per barrel (27.5% higher than 2005 prices) Food crisis continues with prices still 57.6% higher than in 2005. Sept. 2009 (sign of Recovery, Poor still Hurting) # GDP decline slow or end in many advanced economies, but recovery of employment expected to lag. # 43 poorest countries are still suffering and will need additional assistance to move beyond the global recession. Sept. 2009 (Responsible Globalization) # World Bank President Robert Zoellick outlines new vision for a world post financial crisis. # In a speech , Zoellick says, ” Coming out of this crisis ,we have an opportunity to reshape our policies and institution”. (Reference : http:/ www.worldbank .org/financial crisis/) Conclusion Financial crisis is a situation when value of some assets decreases or GDP becomes negative which is not at all good for an economy. This crisis came in to effect from Sept. 2007 and still some countries like US is under the effect or we can say are still under crisis.
This can be easily seen when in latest times as Obama The president of US visited India and took over 50000 jobs for US so called the developed country. The effect was seen at the time when Lehman Brothers a great bank of US collapsed in 2008. This was all due to over prodection and giving loans without any security and the further reason for such is no savings by the people of US. The effect of such crisis is not seen on India or was negliable because the savings habit of Indians. The most affected sector was Financial sector whereas the least affected was or is IT sector. In the end it can be said that to avoide the effect of Financial crisis one should start saving for an uncertain future.
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