Financial Crisis to a Global One Finance Essay

Factors that led the US Economy to the Financial Crisis of 2007 and the Mechanisms of Transmission to a Worldwide Crisis

During these last few years the most important economic event has affected the worldwide economy has been the financial crisis. There is no precise definition of financial crisis, but a common view is that disruptions in financial markets rise to the level of a crisis when the flow of credit to households and businesses is constrained and the real economy of goods and services is adversely affected. [1] Being students of economics branch, we are continuously studying about the economic models, theories and development of a variety of economic structures. Such event as the financial crisis has really fascinated us and motivated to deepen our knowledge regarding its importance and characteristics. It is stated that this financial crisis is the most important and in the meantime the most dramatic one since the Great Depression of 1930s.

Considering the importance of such an economic event, we wanted to understand the structure of a financial crisis, the causes that led to it describing specifically the relations between them and the mechanisms of transmission from one step to another; from the starting point to the spread of the crisis within the country of origin and afterwards all over the world. This will provide us with information about the real economy and how it constantly adapts to these happenings.

The structure of our paper consists in first explaining the factors that led to the beginning of the financial crisis, which are part of the first chapter and which include War in Iraq, the securitization process, the subprime mortgages and the housing bubble effect. The development of the crisis within the country of origin will be explained in the second chapter; here we have to mention the mechanism of transmission from the financial crisis to the economic one. And in the third and last chapter we will explain channels in which the crisis became global the so called Contagion Process.

The factors that led the American Economy to the Financial Crisis

War in Iraq

After the suicide attacks byA  Al-Qaeda terroristsA upon the United States on September 11, 2001, in the World Trade CenterA in New York City, the situation of the economy became even worse. This contributed to the loss of business on Wall Street, the Dow Jones [2] industrial average closed down more than 684 points, or more than 7% (dropping below the 9000 mark at 8921, according to preliminary figures), on extraordinarily heavy New York Stock Exchange (NYSE) volume. The Nasdaq [3] composite index dropped by 109 points, or 6.5%, to 1586, leaving the already battered index at its lowest point since October 1998.

Besides these devastating losses, the war in Iraq, which began on March 20, 2003, as a counteraction to the terrorists attack, has come at a great cost to the American economy. According to Nobel Prize-winning economist Joseph Stiglitz the Iraq war has cost the US 50-60 times more than the Bush administration predicted and was a central cause of the sub-prime banking crisis threatening the world economy [4] He calls it a hidden cause of the current credit crunch. To fight against it, the US central bank responded to the massive financial drain of the war by flooding the American economy with cheap credit. What happened than will be explained later. But before we go there, we also have to mention that in the short run, wartime spending actually stimulates the economy. As another Nobel Prize-winning economist, Paul Krugman argues, the war is indeed a grotesque waste of resources, but we can't blame it for the current economic mess. "Remember, the lowest unemployment rate America has experienced over the last half-century came at the height of the Vietnam War." [5] 

Securitization Process

Securitization is a financial instrument that appeared at the American economy at the beginning of 1980s. It is referred as distribution of default risk by grouping debt obligations(such as mortgages) into a pool, and then selling securities backed by this pool. In other words this means that in order for the banks to ensure funds for their normal and ongoing activity they gave loans to people who became debtors. This money was tied up in banks and they couldn't make any profit of it(except for the part when the loan would be returned which would actually be in a long-term period). In order to profit from the loaning process banks turned these loans into securities; they divided the credits into parts and sold them to other people (security buyers) as obligations with considerably high interest rates. It is estimated about 10% interest rates for these obligations in 2006.

In this way the person who had taken the loan from the bank was not a debtor of that bank where he had taken his loan from, but to the buyer of the obligation with his mortgage credit. This process was of priority from both sides- banks could take off the risk by selling these loans(and transferring that risk to the people who bought the loans) and the security buyers got regular payments from the debtors. Banks started borrowing money from other banks in order to lend more money to the people so they could increase the level of the loans and sell these loans as securities. Furthermore, one high street bank such as the Lehman Brothers also bought mortgages so it could securitize them and sell them to the others.

At first the people who were profiting the loans were people with sufficient incomes or as it may also be called "safe borrowers". After that the situation changed; banks started giving loans also to poor people, people who had credit level below the usual. These loans are known as the subprime mortgages [6] or "self-certified loans" or also "liar's loans". Banks started buying, selling and trading securitization or as we may say, they started buying, selling and trading risk. What's interesting is that the banks tended to spread the risk to the security buyers.

Furthermore, involved in this mechanism, banks started to invest. These investments were considered high-profit investments because the obligations were with a considerable percentage of profit (about 10 % interest in annual scale as it is mentioned in the first paragraph). But these kinds of obligations were massively supported by subprime credits. Consequently, this meant that these investments were very risky; "not-safe borrowers" would have subsequently problems with paying off the credit. Banks were exposed toward the problems by being engaged in these activities. Securitization was implied to be a productive financial instrument that could help the banks lend more and lower the risk; instead, it led towards a risky and unsecure situation.

When people started seeing the real situation, "the crisis of confidence" spread. Investment banks were sitting on high risk loans. There was an increase in the prices and in the value of the immobile property known as the housing bubble(which will be explained in details later) which led to the process that the security buyers wanted their money back. People didn't have money to pay the loans so the banks found themselves in quite a difficult situation. Lacking in deposits, some of them collapsed. At this point, banks turned to the government for help. More money was injected but still it wasn't enough; the banks went bankrupted and the confidence wasn't restored.

Subprime Mortgages and the subprime "boom"

There are generally two types of mortgages in the US: fixed-rate mortgages (FRMs), which have an interest rate fixed for the life of the loan; and adjustable-rate mortgages (ARMs), which have variable periodic interest rates. Subprime mortgages are defined as mortgages to borrowers with limited credit histories. Between 2003 and 2006, a high number of mortgages were issued to subprime residential borrowers. Many subprime mortgages are a combination of ARMs and FRMs. Such mortgages provide for a fixed rate for the first two to three years, which is known as the "teaser rate," and after that period the interest rate becomes adjustable semiannually.

As real estate prices rose in the early years of this decade, and securitization provided more capital for mortgages, lenders "changed" their underwriting criteria in order to issue more mortgages and turned to subprime lenders. Between 1995 and 2005, subprime mortgages increased from 5% to 20% of the mortgage market. In 1994, $35 billion in subprime mortgages were produced, and by 2006, that number had increased to more than $600 billion, about 17 times more than in 1994. And the most significant cause for this boom appears to be the increase in the securitization of mortgages as it is explained in the first paragraph.

Housing Bubble

"A bubble occurs when exaggerated expectations of future prices increase unusual demand either by people who fear being priced out of a market or by investors hoping to make a lot of money fast. A bubble is a self-fulfilling prophecy for a while, as successive rounds of buyers push prices higher and higher. But the willingness to pay higher and higher prices in fragile: It will end whenever buyers perceive that prices are no longer going up. Hence bubbles carry the seeds of their own destruction. Only time is needed for bubbles to end." [7] 

The current financial crisis started in the United States housing market in 2007. The US housing market is seen by many as the main cause of the financial crisis. The financial turmoil that engulfed the US during 2007-2009 began in the mortgage lending markets. There are two potentially reasons and competing explanations of the origins of this crisis. The first is that the "easy money" policies of the Federal Reserve produced the US housing bubble that is at the core of today's financial crisis. The second and more credible explanation is that it was indeed lower interest rates that spawned the speculative euphoria. As found by Robert Schiller, the inflation-adjusted house prices had been remained constant in the period 1895-1995. But he also found that the real house prices in 2002 had rosen almost 30% after adjusting from inflation. This led him think that there would be such a phenomenon called "housing bubble"

The rise in house prices caused large increases in demand for houses, but the supply remained the same. The increase in the demand is attributed to a number of factors such as:

Low mortgage rates. Even though the US savings rate was low during the housing bubble, a flow of savings entering the US economy from countries such as Japan and China helped to keep mortgage rates low.A 

Relaxed standards for mortgage loans.A Standards for mortgage loans were "changed" as a result of a number of factors: new governmental policies aimed to adopt an increase in home-ownership rates among lower-income households and also greater competition in the mortgage loan market.

Low short-term interest rates. The Fed funds rate began in 2001 at 6.25% and ended at 1.75% level at the same year. If the course of housing bubble in the US would have follow the same way as in Japan, the housing bubble would have collapse along with the collapse of the stock bubble in the years 2000-2002. Instead, the collapse of the stock bubble helped to feed the housing bubble, because the loss of faith in the stock market caused that a large number of people turned to investments in immobile property as a better alternative than the stock market. In addition, the economy was very slow recovering from the 2001 recession. The weakness of the recovery of economy, led the Federal Reserve Board to continue cutting interest rates, pushing the Fed funds rate in mid-2003 to a record of 50-years to the level of 1%, where it stayed for a year. In purchasing-power terms, a borrower during that period who merely invested in goods, whose prices merely rose at the rate of inflation, was profiting in proportion to what he borrowed. In this way, unconsciously, Fed created a credit bubble. But Fed says that the reason of a very low interest rate choice in 2003 and 2004 was that they ignored the dollar weakness, higher interest rate choices abroad, the Taylor Rule [8] and the booming performance of the US and global economics.

Affected by some factors, housing bubble burst in 2006. First, average hourly wages in U.S had remained stagnant or declined 2002 until 2009; in real term this represented a decline. Second, growth in the supply for houses tracked price rises. Third, as interest rate rose to a peak of 5.25%, adjustable-rate mortgages (ARMs) become less attractive and so removed many non-prime prospective buyers from the market. Fourth, as house prices fell, home-owners unable to take monthly payments, lost their houses in foreclosures, while banks and other mortgage-lenders lost hundreds of billions (unable to recover amounts loaned).

By the beginning of 2007 these changes happened:

A¢â‚¬A¢ Home prices were at unprecedented levels.

A¢â‚¬A¢ Mortgage quality had declined substantially.

A¢â‚¬A¢ Asset-backed securitizations had spread well.

This is determined as the beginning of the subprime mortgage crisis. But how did we get to the Financial Crisis? We will try to explain all the mechanism in the upcoming chapter.

From the Financial Crisis to the Economic one

Because of the rising of the interest rates due to the inflation, the debtors were unable to return the money to the banks. Based on the lending contract, if they couldn't pay the borrowed money back by the end of the maturity of the mortgage, they were obligated to consign their houses to the banks. Millions of home-owners lost their houses. Even though banks had the right of the ownership over the houses, the level of the bank reserves was minimal, because of the non-pay backed loans. In order to profit from the ownership of the houses banks tried to sell them, but the great supply of the houses derived an unpredicted result; people didn't need the houses and moreover, they couldn't pay for them. This led to the devaluation of the house prices. By the firstA quarter of 2009, home prices had decreased by over 32% from their 2006 peak.A A However, home prices were still 50% higher than they had been in the firstA quarter of 1998. Contrary to the housing bubble process, the house prices declined dramatically. Banks couldn't get enough money to cover the original inflated loans by selling the foreclosed properties. The "bust" quickly spread and the crisis had affected the general economy.

At this moment distress among subprime mortgage lenders was visible. Some of the top investment banks either failed or were taken over. The deepening crisis in the subprime mortgage market had affected the investors' confidence. Confidence was also shaken in many financial institutions so banks began to avoid engaging in any interbank lending activity. But those transactions are the engine of the entire economy. The credit crunch became a visible crisis when there was zero liquidity in the market. That is the point where subprime crisis crossed the border and turned into the credit crisis (crunch).

On December 1, 2008, the National Bureau of Economic Research announced that the economy had entered into a recession in December of 2007. Real GDP increased by only 1.1% for the year 2008. Real GDPA decreasedA at annual rates of 6.3% in the 4th quarter of 2008 and of 5.7% in the 1stA quarter of 2009. The unemployment rate increased from 4.9% in December of 2007 to 9.5% in June of 2009.

From the Economic Crisis to the Global one

In this chapter we will see how the economic crisis in the US became a global crisis and which are the channels in which it passed, by differing them in two parts: the transmission mechanism the developed countries and in the developing ones. This process is also called "Contagion" [9] and has a big importance to us, because it lets us understand how the global economy interacts.

Developed Countries

To explain how the economic crisis spread throughout the world let's take the example of two international trade giants such as Toyota (the world's largest automobile producer, headquartered in Tokyo, Japan) and Caterpillar of Peoria, Illinois (the world's largest producer of heavy construction equipment and vehicles). Toyota's US sales consists of one-third of the company's total sales. The current recession caused Toyota's sales in the United States to fall by 37 percent in December 2008 and by 32 percent in January 2009. This, not surprisingly, led to cutbacks in production, and so announced a reduction in employment.

In the example of Caterpillar of Peoria, in the other hand, we conclude that its sales, of which 60 percent are typically outside North America, fall dramatically in late 2008. In anticipation of the global economy continuing to weaken in 2009, Caterpillar announced in January that it was reducing employment by 20,000 workers.

By reducing the workforce these companies have indirectly decreased the demand on goods and services in both countries (US and Japan), leading to the global crisis. International trade (Import-Exports) between and among countries means that what happens in one nation's economy can have a dramatic effect on that of others.

Developing Countries

The economic downturn in developed countries have significant impact on other world's develA­oping countries. But how can this happen? The channels of impact on developA­ing countries include:

A¢â‚¬A¢ Trade and trade prices. Growth in China and India, as developed countries, has increased imports and pushed up the demand for goods and services, which has led to greater exports and higher prices, for example from African countries. Eventually, a slow down on the growth rate of the economy of China and India has led to a decrease of exports of the developing countries.

A¢â‚¬A¢ Remittances. There will be fewer economic migrants coming to developed countries when they are in a recession, so fewer remittances and also probably lower volumes of remittances per migrant.

A¢â‚¬A¢ Foreign direct investment (FDI). The process of securitization, as shown before, insured the investors with obligations and increased the level of investments within the US and abroad. But these obligations were based in risky borrowers, and so they never got their money back. The result is that they can't invest in the developing countries, causing an economic crisis there.

A¢â‚¬A¢ Commercial lending. Banks under pressure in developed countries may not be able to lend as much as they have done in the past.

A¢â‚¬A¢ Aid. Aid budgets are under pressure because of debt problems and weak fiscal positions, and this will be reflected in the developing countries economies.

Each of these channels needs have direct consequences for growth and development. The impact on developing countries will vary. It will depend on the response in developed countries to the financial crisis and the slowdown, and the economic characteristics and policy responses, in developing countries.

Conclusions

In the end of this paper we would like to summarize some of the most important conclusions we found about the Financial Crisis. First, we have to mention that the crisis has its roots in some key factors; they all together led the American Economy and the World into the crisis. These factors include the War in Iraq, which contributed in the decline of the American economy as a whole. The reaction of the Fed by cheapening the credit led the banks to a "risky initiative": the Subprime Mortgages. Followed by the securitization process, which on one hand creates diversification and liquidity, but on the other hand resulted to be risky, if not well understood by the investors, it created such a situation in which the debtors could not pay their money back. This caused the so called Housing Bubble.

From the housing bubble the American economy passed to the devaluation of the house prices and the so called "Crisis of Confidence". This is the point in which the financial crisis began leading the banks to a very low liquidity level and made it impossible for them to go on with their transactions. All this affected the American economy as a whole and transformed the crisis into an Economic Crisis.

As the American economy dropped, the effects would be present in the other countries too. And this because channels in which the crisis was transmitted all over the world. These channels may be seen in two different point of views: in developed countries (which are strongly related with the American economy) and in developing countries(which are indirectly related with it). The most important channel through which the crisis spread is the foreign trade which includes import and export of the US to other countries and vice versa. But there are also other channels as remittances, foreign direct investments, commercial lending and aid, which delivered the crisis in all the countries around the world.

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