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CURRENT GLOBAL FINANCIAL CRISIS & ITS

IMPLICATION TO INTERNATIONAL FINANCIAL

INSTITUTION: THE CASE OF US REGION

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1.0 Abstract

The current economy situation of United States towards the current global financial crisis that

affected entire country in the whole world with the factor of current global financial crisis, the

implication into international financial institution, the effect into International Financial Institution

and the government give responses towards the current global financial crisis and International

Financial Institution. The financial institution crisis hit its peak in September and October 2008.

The global financial crisis in US also affected to International Finance Corporate (IFC).

2.0 Introduction.

In the late 1920s, US were experienced with the Great Depression where stock market booms.

Great Depression was series of banking in the US beginning in October 1930 were not

successfully allayed by the Federal Reserve (Friedman and Schwartz, 1971) and turned to the

bad situation. The depression was experienced around the world by the fixed exchange rate

links of the gold exchange standard and numerous protectionist measures. Many countries

across the world were finally hit by debt and currency crises. After WWII, the world economy in

stabile because of Bretton Woods (BW) system where the currencies were kept fixed, capital

controls were widespread and financial regulation was strictly designed to prevent a repeat of

the financial disturbance in the interwar period. Bretton Woods (BW) systems were applied in

1971 and show that the capital flows surged. In addition, rate of inflation was high, and controls

on the financial system began to collapse and financial crisis problem unfortunate comeback. It

resulted in the collapse of large financial institutions, the bailout of banks by national

governments and decline in stock markets which suffered around the world. In whole regions,

the housing market also suffered in 2007 caused the values of securities tied to U.S. real estate

pricing decline and damaging financial institutions globally, resulting in evictions, continued

unemployment and foreclosures.

Late 2000s the "Great Recession" was emerged in 2007 appears at the lowest level,

although unemployment continues to increase. Many small banks and households’ still face

bigger problems in bring back their balance sheets. High rates of home foreclosures happened

with combination of the unemployment with sub-prime loans. The Great Recession has

affected the whole world economy, with higher effect in some countries than others. The U.S.

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economy has declined by 1.0% in the second quarter, much less than the 6.4% decline in the

first quarter. The Great Recession ended in the U.S. in mid 2009. Here the revolution during

2007 until 2009 toward U.S. In 2007, sub-prime mortgages was declined the US debt status

and be last point. On 9 August 2007, the seizure in the banking system was happened which

triggered by BNP Paribas. BNP Paribas announcing that it was stop their activity especially in

hedge funds which included three in US mortgage debt. This moment it became clear that

there were tens of trillions of dollars worth of derivatives swilling round which were worth was

unexpected by the banker. On 15 September 2008, financial crisis to come to U.S and took a

year only. For example, US government allowed the investment bank Lehman Brothers to go

bankrupt and assumed that intervention from governments can bail out any bank that got into

serious trouble. The U.S government finding buyer from Bear Stearns whiles the UK had

nationalized Northern Rock. When Lehman Brothers was bankruptcy, they assume that all big

banks will bankruptcy because more risky. Within a month, the assumptions were truth and

forced western governments to injected larger sums of capital into their banks to prevent the

bank’s collapse. The banks were rescued in short period of time, but it was too late to prevent

the global economy from going into fall. Credit flows to the private sector were retarded. This is

because consumer and business decrease confidence. After a period of high oil prices, it’s

come to persuaded central banks to keep interest rates high to against inflation rather than to

cut them in anticipation of the financial crisis spreading to the real economy. On 2 April 2009,

G20 group of developed and developing nations at London world leaders committed

themselves to a $5tn (£3tn) fiscal development, an extra $1.1tn of resources to help the

International Monetary Fund and other global institutions increase jobs and growth, and to

reform of the banks.

On 9 May 2010 it’s be focus of concern switched from the private sector to the public

sector because the IMF and the European Union declare they would supply fund to help

Greece. Greece had problems as it covered its public finances and facing difficult stages in

collecting taxes, but other countries started to become worry about the size of Greece budget

deficits. It’s affecting policy decisions in the UK, the euro zone and, most recently in the US.

The morphing of a private debt crisis into a sovereign debt crisis that was complete when the

rating agency, S&P, waited for Wall Street to shut up shop in weekend before declared that

America's debt no longer is classed as top-notch triple A. it’s become worst time and the

biggest sell-off in stock markets since late 2008. The US is drowning in negative equity and

foreclosed homes were terrible news for Barack Obama because not delivered economic

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recovery. Fiscal policy will be tightened over the coming months as tax breaks expire and

public spending is cut. There will be a long period of weak growth and high unemployment. The

banks pay down the excessive levels of debt collected in the bubble years and the global

economy will be decline back into recession.

3.0 Scope of study

The scope of study is reviews of the current economy situation of United States towards the

current global financial crisis that affected entire country in the whole world. In this research we

want to know the implication of United States to the International Financial Institution that

including the implication, effect and government responses whether US recover or not based

on factors in current global financial crisis such as subprime mortgage, asset bubble and lastly

the credit crunch.

4.0 Objective

1. To identify the three main factor of current global financial crisis in US

2. To determine the implication into International Financial Institution in US.

3. To identify the effect into International Financial Institution in US.

4. To determine the government responses of US towards the current global financial

crisis and International Financial Institution in US.

5.0 Literature Review

In September and October 2008, the US suffered a severe financial dislocation that saw a

number of large financial institutions collapse. Although this shock was of particular note, it is

best understood as the culmination of a credit crunch that had begun in the summer of 2006

and continued into 2007. The US housing market is seen by many as the root cause of the

financial crisis. Since the late 1990s, house prices grew rapidly in response to a number of

contributing factors including persistently low interest rates, over-generous lending and

speculation. The bursting of the housing bubble, in addition to simultaneous crashes in other

asset bubbles, triggered the credit crisis. However, it was the complex web of financial

innovations that had purportedly been employed to reduce risk which ensured that the crisis

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spread across the financial markets and into the real economy. In particular, all manner of

profit-seeking financial institutions used a complex financial process characterised by highly

leveraged borrowing, inadequate risk analysis and limited regulation to bet on one outcome a

bet which proved to be misguided when asset prices collapsed.

As Ben S. Bernanke, 1983 recognized that its effects via the money supply, the

financial crisis of 1930-33 affected the macro economy by reducing the quality of certain

financial services, primarily credit intermediation. The basic argument is to be made in two

steps. First, it must be shown that the disruption of the financial sector by the banking and debt

crises raised the real cost of intermediation between lenders and certain classes of borrowers.

Second, the link between higher intermediation costs and, the decline in aggregate output must

be established. There are many ways in which problems in credit markets might potentially

affect the macro economy. Several of these could be grouped under the heading of "effects on

aggregate supply". For example, if credit flows are dammed up, potential borrowers in the

economy may not be able to secure funds to undertake worthwhile activities or investments at

the same time, savers may have to devote their funds to inferior uses.

About the cause of current crisis Stephen said US house prices rose dramatically from

1998 until late 2005, more than doubling over this period, and far faster than average wages.

Further support for the existence of a bubble came from the ratio of house prices to renting

costs which rocketed upwards around 1999. (Stephen, 2008). Furthermore, Yale economist

Robert Schiller found that inflation-adjusted house prices had remained relatively constant over

the period 1899-1995. Pointing to the escalation in house prices and marked regional

disparities, Shiller correctly predicted the imminent collapse of what he believed was a housing

bubble. (Robert Shiller, 2005). In addition, individual-level analysis by Demyanyk and van

Hemert finds that, controlling for borrower and loan characteristics as well as macroeconomic

conditions, the credit quality of new subprime mortgages fell each year from 2001 to 2006. (

Yuliya, Hemert,2008). In other cases, there existed an incentive to voluntarily foreclose where

the value of the house and future gains associated with a stronger credit rating was smaller

than the value of the outstanding mortgage because of generous foreclosure legislation.

(Anthony,2008).

Avoiding financial instability requires several types of institutional reforms. First,

prudential regulation of the banking and financial system must be strengthened in order to

prevent these types of financial crises. (Mishkin, 2003). Second, the safety net provided by the

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domestic government and the international financial institutions set up by Bretton Woods might

need to be limited in order to reduce the moral hazard incentives for banks to take on too much

risk. (Demirguc-Kunt and Kane, 2002), Third, currency mismatches need to be limited in order

to prevent currency devaluations from destroying balance sheets. Although prudential

regulations to ensure that financial institutions match up any foreign-denominated liabilities with

foreign-denominated assets may help reduce currency risk, they do not go nearly far enough.

(Mishkin,1996). Fourth, policies to increase the openness of an economy may also help limit

the severity of financial crises in emerging market countries. The reason why openness may

affect financial fragility is that businesses in the tradable sector have balance sheets which are

less exposed to negative consequences from a devaluation of the currency when their debts

are denominated in foreign currency. Because the goods they produce are traded

internationally, they are more likely to be priced in foreign currency.

Governments are providing support and doing what so ever they can to prevent their

economical structure US government injected $800 billion in the economy to support the

structure, UK government has announced a package of $692 billion, European Union is about

to start an economic recovery plan and IMF has called for minimum financial support of $100

billion (BBC news, 2008). Also on the research part, E. Philip Davis and Dilruba Karim

suggested an “Early warning System” to cop better with such crisis; the proposed two models

“Logit” as a global early warning system and “Signal Extraction” for country specific early

warning system. DeBoer (2008) believe that such bailout programs and other supporting

packages from governments is like offering protection from a negative outcome which is more

appropriate to be called as “moral hazard” this trend could increase the possibility of future bad

upshots. Warne (2008) believes that it’s the matter of confidence of investors, as long as it is

restored, crisis will be over; but it cannot be done when we daily hear news about the

abandonment of financial institutions, it needs some financial stability. OECD Secretary

general, Gurria (2008) hopes that the effective macroeconomic policies and vital financial

reforms will turn down the heat and normal financial conditions as well as the growth rates will

return to normal in 2009. Yilmaz (2008) acknowledged that the worst part of the crisis is already

over and the markets are suffering from what can be called ‘the after shocks’. Sha Zukang

(2008) says that normalization of economic activities need “global and symentic” solutions, he

stated that current “global Economic Governance System” is derisory for the prevention of such

crisis. Governments on the other hand are doing what so ever they can to prevent their

financial institutes to fall and protect their economical structure.

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Last IMF/World Bank need to made a strong pitch for changes in the operating

framework of the multilateral financial institutions. This framework needs to puts per capita

income as the defining parameter for the assistance from the IFI’s. On that basis, US, where

per capita income is high by developing-country standards, is not eligible for special

concessionary assistance. The essence of US case is that notwithstanding our high per capita

incomes, the US faces specific vulnerabilities arriving from small size, susceptibility to natural

disasters and the impact of climate change and the very high public debt ratio. The lessons that

this crisis holds for the region that the last few months should forcefully bring to us, it should be

that, in this new global environment, deeper regional integration is absolutely critical for the

survival of all the economies. It is clearly a case of we swim together or we sink together

admittedly some faster than others. For years, we have talked closer integration. This would

seem to be the time to accelerate our efforts. We need to seriously consider and expedite

several things such as, to bring regional production structures into better alignment. Second,

the region needs to develop a policy agenda to improve its resilience in future crises. Third, we

need to quickly upgrade and harmonize regulatory and supervisory systems and put in place

mechanisms for regional regulatory coordination. Last but not least as the EU has shown, the

creation of a more cohesive regional economic and political bloc will strengthen our capacity to

bargain collectively with international financial institutions like the IMF, World Bank and WTO

and the OECD.

6.0 Discussion and Findings

6.1 Factor of current global financial crisis

United States was born from the Britain’s American colonies broke with the mother country in

1776 and were recognized as the new nation of the United States of America following the

Treaty of Paris. US has the largest and most technologically powerful economy in

the world, with a per capita GDP of $48,100.The crisis in 2007 in the United

States directly due to the collapse of the housing bubble in the United States in 2006, which

resulted in about October 2007, the so-called crisis of subprime mortgages. The impact of the

mortgage crisis began to manifest itself in an extremely serious since the beginning of 2008,

getting first to the U.S. financial system, and then to international, resulting in a serious liquidity

crisis, and causing, indirectly, other economic phenomena, such as a global food crisis,

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different stock collapse (like the stock in January 2008 and the global stock market crisis of

October 2008) and, overall, an economic crisis at international level.

The subprime mortgage crisis, popularly known as the “mortgage mess” or “mortgage

meltdown,” came to the public’s attention when a steep rise in home foreclosures in 2006

spiralled seemingly out of control in 2007, triggering a national financial crisis that went global

within the year. Consumer spending is down, the housing market has plummeted, foreclosure

numbers continue to rise and the stock market has been shaken. The immediate cause or

trigger of the crisis was the bursting of the United States housing bubble which peaked in

approximately 2005–2006. Already-rising default rates on "subprime" and adjustable rate

mortgages (ARM) began to increase quickly thereafter. As banks began to give out more loans

to potential home owners, housing prices began to rise. As banks began to give out more loans

to potential home owners, housing prices began to rise. Banks would encourage home owners

to take on considerably high loans in the belief they would be able to pay them back more

quickly, overlooking the interest rates.

Once the interest rates began to rise in mid 2007, housing prices dropped significant

and resulting the number of foreclosed homes also began to rise. As part of the housing and

credit booms, the number of financial agreements called mortgage-backed securities (MBS)

and collateralized debt obligations (CDO), which derived their value from mortgage payments

and housing prices, greatly increased. Such financial innovation enabled institutions and

investors around the world to invest in the U.S. housing market. As housing prices declined,

major global financial institutions that had borrowed and invested heavily in subprime MBS

reported significant losses. Falling prices also resulted in homes worth less than the mortgage

loan, providing a financial incentive to enter foreclosure. The ongoing foreclosure epidemic that

began in late 2006 in the U.S. continues to drain wealth from consumers and erodes the

financial strength of banking institutions.

Defaults and losses on other loan types also increased significantly as the crisis

expanded from the housing market to other parts of the economy. Total losses are estimated in

the trillions of U.S. dollars globally. While the housing and credit bubbles were building, a series

of factors caused the financial system to both expand and become increasingly fragile, a

process called financialization. The crisis directly due to the collapse of the housing bubble in

the United States in 2006, which resulted in about October 2007, the so-called crisis of

subprime mortgages. The percentage of new lower-quality subprime mortgages rose from the

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historical 8% or lower range to approximately 20% from 2003–2006, with much higher ratios in

some parts of the U.S. A high percentage of these subprime mortgages, over 90% in 2006 for

example, were adjustable-rate mortgages. These two changes were part of a broader trend of

lowered lending standards and higher-risk mortgage products. After U.S. house sales prices

peaked in mid-2006 and began their steep decline forthwith, refinancing became more difficult.

As adjustable-rate mortgages began to reset at higher interest rates (causing higher monthly

payments), mortgage delinquencies soared. Securities backed with mortgages, including

subprime mortgages, widely held by financial firms, lost most of their value.

Global investors also drastically reduced purchases of mortgage-backed debt and

other securities as part of a decline in the capacity and willingness of the private financial

system to support lending. Lenders began originating large numbers of high risk mortgages

from around 2004 to 2007, and loans from those vintage years exhibited higher default rates

than loans made either before or after. An increase in loan incentives such as easy initial terms

and a long-term trend of rising housing prices had encouraged borrowers to assume difficult

mortgages in the belief they would be able to quickly refinance at more favorable terms.

Once interest rates began to rise and housing prices started to drop moderately in 2006–2007

in many parts of the U.S., refinancing became more difficult. Defaults and foreclosure activity

increased dramatically as easy initial terms expired, home prices failed to go up as anticipated,

and ARM interest rates reset higher. Falling prices also resulted in 23% of U.S. homes worth

less than the mortgage loan by September 2010, providing a financial incentive for borrowers

to enter foreclosure.

Subprime mortgages remained below 10% of all mortgage originations until 2004,

when they spiked to nearly 20% and remained there through the 2005-2006 peak of the United

States housing bubble. Some long-time critics of government claim that the roots of the crisis

can be traced directly to risky lending by government sponsored entities Fannie

Mae and Freddie Mac. Freddie Mac CEO Richard Syron agreed with Greenspan that the

United States had a housing bubble and concurred with Yale economist Robert Shiller’s 2007

warning that home prices “appeared overvalued” and that the necessary correction could “last

years with trillions of dollars of home value being lost.” Greenspan also warned of “large double

digit declines” in home values, much larger than most would expect. Subprime borrowers

typically have weakened credit histories and reduced repayment capacity. Subprime loans

have a higher risk of default than loans to prime borrowers. If a borrower is delinquent in

making timely mortgage payments to the loan servicer (a bank or other financial firm), the

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lender may take possession of the property, in a process called foreclosure. Subprime lending

was a major contributor to this increase in home ownership rates and in the overall demand for

housing, which drove prices higher.

The credit and house price explosion led to a building boom and eventually to a surplus

of unsold homes, which caused U.S. housing prices to peak and begin declining in mid-2006.

Easy credit, and a belief that house prices would continue to appreciate, had encouraged many

subprime borrowers to obtain adjustable-rate mortgages. These mortgages enticed borrowers

with a below market interest rate for some predetermined period, followed by market interest

rates for the remainder of the mortgage's term. Borrowers, who would not be able to make the

higher payments once the initial grace period ended, were planning to refinance their

mortgages after a year or two of appreciation. But refinancing became more difficult, once

house prices began to decline in many parts of the USA. Borrowers who found themselves

unable to escape higher monthly payments by refinancing began to default. This credit and

house price explosion led to a building boom and eventually to a surplus of unsold homes,

which caused U.S. housing prices to peak and begin declining in mid-2006. Easy credit, and a

belief that house prices would continue to appreciate, had encouraged many subprime

borrowers to obtain adjustable-rate mortgages.

These mortgages enticed borrowers with a below market interest rate for some

predetermined period, followed by market interest rates for the remainder of the mortgage's

term. Borrowers who would not be able to make the higher payments once the initial grace

period ended were planning to refinance their mortgages after a year or two of appreciation.

But refinancing became more difficult, once house prices began to decline in many parts of the

USA. Borrowers who found themselves unable to escape higher monthly payments by

refinancing began to default. By September 2008, average U.S. housing prices had declined by

over 20% from their mid-2006 peak. This major and unexpected decline in house prices means

that many borrowers have zero or negative equity in their homes, meaning their homes were

worth less than their mortgages. As of March 2008, an estimated 8.8 million borrowers to

10.8% of all homeowners had negative equity in their homes, a number that is believed to have

risen to 12 million by November 2008.

By September 2010, 23% of all U.S. homes were worth less than the mortgage

loan. Borrowers in this situation have an incentive to default on their mortgages as a mortgage

is typically nonrecourse debt secured against the property. Economist Stan Leibowitz argued in

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the Wall Street Journal that although only 12% of homes had negative equity, they comprised

47% of foreclosures during the second half of 2008 and concluded that the extent of equity in

the home was the key factor in foreclosure, rather than the type of loan, credit worthiness of the

borrower, or ability to pay. Increasing foreclosure rates increases the inventory of houses

offered for sale. The number of new homes sold in 2007 was 26.4% less than in the preceding

year. By January 2008, the inventory of unsold new homes was 9.8 times the December 2007

sales volume.

The United States housing bubble is an economic bubble affecting many parts of

the United States housing market in over half of American states. Housing prices peaked in

early 2006, started to decline in 2006 and 2007. Increased foreclosure rates in 2006–2007

among U.S. homeowners led to a crisis in August 2008 for the subprime, collateralized debt

obligation (CDO), mortgage, credit, hedge fund, and foreign bank markets. In October 2007,

the U.S. Secretary of the Treasury called the bursting housing bubble "the most significant risk

to our economy. The derivatives such as mortgage-backed securities were insured by credit

default swaps or so investors thought. Hedge fund managers created a huge demand for these

supposedly risk-free securities, and therefore the mortgages that backed them.

To meet this demand for mortgages, banks and mortgage brokers offered home loans

to just about anyone. This drove up demand for housing, which homebuilders tried to meet.

Many people bought homes, not to live in them or even rent them, but just as investments to

sell as prices kept rising. When the homebuilders finally caught up with demand, housing prices

started to fall in 2006. This burst the asset bubble, and subsequently led to the subprime

mortgage crisis in 2006, the banking credit crisis in 2007 and finally the global financial crisis in

2008. Housing bubbles may occur in local or global real estate markets. In their late stages,

they are typically characterized by rapid increases in the valuations of real property until

unsustainable levels are reached relative to incomes, price-to-rent ratios, and other economic

indicators of affordability. This may be followed by decreases in home prices that result in many

owners finding themselves in a position of negative equity—a mortgage debt higher than the

value of the property. The underlying causes of the housing bubble are complex. Factors

include tax policy (exemption of housing from capital gains), historically low interest rates, lax

lending standards, failure of regulators to intervene, and speculative fever. This bubble may be

related to the stock market or dot-com bubble of the 1990s. This bubble roughly coincides with

the real estate bubbles of the United Kingdom, Hong Kong, Spain, Poland, Hungary and South

Korea.

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The impact of booming home valuations on the U.S. economy since the 2001–

2002 recession was an important factor in the recovery, because a large component of

consumer spending was fuelled by the related refinancing boom, which allowed people to both

reduce their monthly mortgage payments with lower interest rates and withdraw equity from

their homes as their value increased. On the basis of 2006 market data that were indicating a

marked decline, including lower sales, rising inventories, falling median prices and increased

foreclosure rates some economists have concluded that the correction in the U.S. housing

market began in 2006.

One possible cause of bubbles is excessive monetary liquidity in the financial system,

inducing lax or inappropriate lending standards by the banks, which asset markets are then

caused to be vulnerable to volatile hyperinflation caused by short-term, leveraged speculation.

Asset bubble is formed when the prices of specific asset classes are over-inflated due to

excess demand for the asset as an investment vehicle. Prices rise quickly over a short period

of time, and are not supported by underlying demand for the product itself. An asset bubble can

be aggravated by a supply shortage, or an over-expansion of the money supply, but most

modern asset bubbles are primarily a result of demand-pull inflation. It is a form of inflation that

is not always accurately captured in the Consumer Price Index (CPI). For that reason, asset

bubbles can be aggravated by low interest rates.

The Federal Reserve reduced interest rates to an extreme low of 1% so that after

inflation there were negative interest rates. As a result of this, mortgage rates fell to a historical

low. A significant change in the market (interest/mortgage rates) combined with an increased

supply of money is the perfect formula for an Asset Bubble. Due to these low rates, the supply

of money was high and the economy saw a huge increase in its people

borrowing. Commercial Banks had doubled the amount of real-estate loans they would

normally issue. There all-time low interest loans were extended to people with worse and worse

credit ratings. The knock-on effect of this was a huge increase in the demand for properties,

housing and other real estate assets. The bubble began to grow and the value of the real

estate assets shot up. The mortgages the banks were lending carried huge risk as many were

lent to people with poor credit histories securitization of the loans (bundling loans banks have

issued together so they can be sold, at profit, to another bank) disguised a lot of the risk. As

borrowers slowly began to default on their loans and declare bankruptcy, banks began to

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realise that they had underestimated the risk and the value of the securities began to fall and

sent the US into recession.

Between 2004 and 2006, the Federal Reserve Board raised interest rates 17 times,

increasing them from 1 percent to 5.25 percent. The Fed stopped raising rates because of

fears that an accelerating downturn in the housing market could undermine the overall

economy. Some economists, like New York University economist Nouriel Roubini, feel that the

Fed should have tightened up on the rates earlier than it did “to avoid a festering of the housing

bubble early on.” Roubini also warned that because of slumping sales and prices in August

2006, the housing sector was in “free fall” and would derail the rest of the economy, causing a

recession in 2007.The credit crunch is affecting businesses and consumers alike. On the

business end, many companies are finding it difficult to obtain large loans in order to expand

operations, or in some cases pay operating expenses. Many companies are in serious financial

trouble and layoffs are a distinct possibility. In 2008, a series of bank and insurance company

failures triggered a financial crisis that effectively halted global credit markets and required

unprecedented government intervention. Fannie and Freddie Mac (FRE) were both taken over

by the government. Lehman Brothers declared bankruptcy on September 14th after failing to

find a buyer.

Bank of America agreed to purchase Merrill Lynch (MER), and American International

Group (AIG)was saved by an $85 billion capital injection by the federal government. Shortly

after, on September 25th, J P Morgan Chase (JPM) agreed to purchase the assets

of Washington Mutual (WM) in what was the biggest bank failure in history. In fact, by

September 17, 2008, more public corporations had filed for bankruptcy in the U.S. than in all of

2007.These failures caused a crisis of confidence that made banks reluctant to lend money

amongst themselves, or for that matter, to anyone. The crisis has its roots in real estate and

the subprime lending crisis. Commercial and residential properties saw their values increase

precipitously in a real estate boom that began in the 1990s and increased uninterrupted for

nearly a decade. Increases in housing prices coincided with the investment and banking

industry lowering lending standards to market mortgages to unqualified buyers allowing them to

take out mortgages while at the same time government deregulation blended the lines between

traditional investment banks and mortgage lenders.

Real estate loans were spread throughout the financial system in the form

of CDOs and other complex derivatives in order to disperse risk, however, when home values

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failed to rise and home owners failed to keep up with their payments, banks were forced to

acknowledge huge write downs and write offs on these products. These write downs found

several institutions at the brink of insolvency with many being forced to raise capital or go

bankrupt. Credit rating agencies are now under scrutiny for having given investment-grade

ratings to MBSs based on risky subprime mortgage loans.

These high ratings enabled these MBS to be sold to investors, thereby financing the

housing boom. These ratings were believed justified because of risk reducing practices, such

as credit default insurance and equity investors willing to bear the first losses. However, there

are also indications that some involved in rating subprime-related securities knew at the time

that the rating process was faulty. Critics allege that the rating agencies suffered from conflicts

of interest, as they were paid by investment banks and other firms that organize and sell

structured securities to investors On 11 June 2008, the SEC proposed rules designed to

mitigate perceived conflicts of interest between rating agencies and issuers of structured

securities. On 3 December 2008, the SEC approved measures to strengthen oversight of credit

rating agencies, following a ten-month investigation that found "significant weaknesses in

ratings practices," including conflicts of interest. Many financial institutions, investment banks in

particular, issued large amounts of debt during 2004–2007, and invested the proceeds

in mortgage-backed securities (MBS), essentially betting that house prices would continue to

rise, and that households would continue to make their mortgage payments. Borrowing at a

lower interest rate and investing the proceeds at a higher interest rate is a form of financial

leverage.

This is analogous to an individual taking out a second mortgage on his residence to

invest in the stock market. This strategy proved profitable during the housing boom, but

resulted in large losses when house prices began to decline and mortgages began to default.

Beginning in 2007, financial institutions and individual investors holding MBS also suffered

significant losses from mortgage payment defaults and the resulting decline in the value of

MBS. In the years leading up to the crisis, the top four U.S. depository banks moved an

estimated $5.2 trillion in assets and liabilities off-balance sheet into special purpose vehicles or

other entities in the shadow banking system. This enabled them to essentially bypass existing

regulations regarding minimum capital ratios, thereby increasing leverage and profits during the

boom but increasing losses during the crisis.

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New accounting guidance will require them to put some of these assets back onto their

books during 2009, which will significantly reduce their capital ratios. One news agency

estimated this amount to be between $500 billion and $1 trillion. This effect was considered as

part of the stress tests performed by the government during 2009. Credit default swaps (CDS)

are financial instruments used as a hedge and protection for debt holders, in particular MBS

investors, from the risk of default, or by speculators to profit from default. As the net worth of

banks and other financial institutions deteriorated because of losses related to subprime

mortgages, the likelihood increased that those providing the protection would have to pay their

counterparties. This created uncertainty across the system, as investors wondered which

companies would be required to pay to cover mortgage defaults. The Financial Crisis Inquiry

Commission reported in January 2011 that CDS contributed significantly to the crisis.

Companies were able to sell protection to investors against the default of mortgage-backed

securities, helping to launch and expand the market for new, complex instruments such as

CDO's. This further fuelled the housing bubble. They also amplified the losses from the

collapse of the housing bubble by allowing multiple bets on the same securities and helped

spread these bets throughout the financial system. Companies selling protection, such as AIG,

were not required to set aside sufficient capital to cover their obligations when significant

defaults occurred. Because many CDS were not traded on exchanges, the obligations of key

financial institutions became hard to measure, creating uncertainty in the financial system

In a June 2008 speech, President of the NY Federal Reserve Bank Timothy Geithner,

who later became Secretary of the Treasury, placed significant blame for the freezing of credit

markets on a "run" on the entities in the "parallel" banking system, also called the shadow

banking system. These entities became critical to the credit markets underpinning the financial

system, but were not subject to the same regulatory controls as depository banks. Further,

these entities were vulnerable because they borrowed short-term in liquid markets to purchase

long-term, illiquid and risky assets. This meant that disruptions in credit markets would make

them subject to rapid deleveraging, selling their long-term assets at depressed prices. He

described the significance of these entities: "In early 2007, asset-backed commercial

paper conduits, in structured investment vehicles, in auction-rate preferred securities, tender

option bonds and variable rate demand notes, had a combined asset size of roughly $2.2

trillion. Assets financed overnight in trip arty repo grew to $2.5 trillion. Assets held in hedge

funds grew to roughly $1.8 trillion.

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The combined balance sheets of the then five major investment banks totaled $4

trillion. In comparison, the total assets of the top five bank holding companies in the United

States at that point were just over $6 trillion, and total assets of the entire banking system were

about $10 trillion." He stated that the "combined effect of these factors was a financial system

vulnerable to self-reinforcing asset price and credit cycles. The securitization markets

supported by the shadow banking system started to close down in the spring of 2007 and

nearly shut-down in the fall of 2008. More than a third of the private credit markets thus

became unavailable as a source of funds. According to the Brookings Institution, the traditional

banking system does not have the capital to close this gap as of June 2009: "It would take a

number of years of strong profits to generate sufficient capital to support that additional lending

volume." The authors also indicate that some forms of securitization are "likely to vanish

forever, having been an artefact of excessively loose credit conditions.

6.2 Implication of US financial crisis towards international financial institution

6.2.1 Regulations and the development of markets

One of the informative studies in the evolution of US security market regulation shown that they

is no binding international financial system and global system coordinated. This condition give

the opportunity to the restrictions between state of the Bank Holding Company in the US

increased banks activities outside the country for a decades and contributed to cross border

regulatory arbitrage. US also as financial holding companies that prohibited from holding non-

financial institutions. These situations contributed to an increasingly interdependent global

economy that tries to fix with the national financial system in the absence of an effective global

framework with full support of all nations. Both national and international markets are tend to

become distorted and also lead to further global financial instability over time.

A number of studies have shown that financial globalization has been slow in slowing

rate in many parts of the world. Obviously, the recent global financial crisis has been impaired

by capital outflow from developing to developed countries and when there is uncertainty

regarding the rate of financial globalization after the global financial crisis. The state banks also

issued notes that were used locally as paper money. Moreover, bank notes of the western

states heavily discounted by the eastern states due to financial mismanagement of some banks

in the western states. In the late of 20th century it can as the emergence of the Euro and the

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European Central Bank. Although there are many numbers of challenges with the fiscal

unification of European countries, nevertheless, economic and financial integration has

reduced to increased efficiency with the emergence of a European Central Bank and a single

European currency. This type of regulation and market development in Europe is come after

disasters and the effects of new national regulatory frameworks in the absence of a globally

integrated system that led to regulatory arbitrage and ineffectiveness of the new national

rules/regulations.

6.2.2 Emergence of international institutions

One of the cases of how a crisis leads to change is the emergence of the US Federal Reserve

System in 1913. During 1837 to 1862 US are using a free banking system, followed by the

National Banking Act introduced during the Civil War. This created a system of national banks

which a system without a central bank. However, a number of banking crises started on 1873

that influence most of the traders and financial players and finally led to the emergence of a

central bank in the US in 1913.

During the Great Depression, US nations responded to the global financial crisis

almost in isolation towards each other. The World Economic Forum as nations took a

nationalistic approach that held in London on 1933 also was a failure. However, in response to

the Great Depression, a number of national rules and regulations were created in isolation from

other nations. Furthermore, some countries took a nationalistic approach that influence to a

number of global issues such as trade with increasing their tariff walls as a way of defending

their domestic. Furthermore, national governments tried to solve their banking crises in

isolation through the implementation to new national policies, rules and regulations such as the

Glass-Steagall in 1933. On 1937 the US economy entered into a double dip recession in 1937

that led the US economy to reduce unemployment and recover from almost a decade of

economic slump.

Eventually, during the Bretton Woods conference that been held during the Great

Depression, the conference and up with the establishment of the International Monetary Fund,

the World Bank and the General Agreements on Tariffs and Trade (GATT) which led to the

formation of the World Trade Organization. The emergence of these international institutions

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contributed to the promotion and better coordination of global financial stability, free trade and

development.

6.2.3 Reforms of the international financial architecture

The recent global financial crisis gives a unique opportunity for both national and international

institutions to determine a number of issues that led to the recent global recession and possibly

ways to improve international financial systems. A study by the IMF (2009a–c) of international

financial architecture stated that the recent global financial crisis has revealed important flaws

in the current global architecture. After the Asian currency crisis, the IMF referred to global

financial stability as a global public good. With increasing of financial globalization, most of the

international community has recognized the importance of global financial stability.

During the recent global financial crisis, international community took the opportunity to

seriously address a number of flaws that have existed in the international financial architecture,

as a securing way for better global financial stability. As a major global forum to deal with the

global economic and financial crisis has been a major development of the global decision-

making process in recent times G20 has been emerge. The G20 agreed with the replacement

of the Financial Stability Forum (FSF) with a new super national board called the Financial

Stability Board (FSB). This Board collaborates with other international institutions that

responsible for safeguarding the global financial stability.

However, the stability of global financial is not a national public good but rather a global

public good. This is because capital and financial products can cross national borders

immediately and sit across many multinational firms’ balance sheets in different parts of the

world. Furthermore, some of these international assets and financial products might contain

toxic components that could profane financial markets of host countries.

6.2.4 New global framework and global leadership

In the past, global financial crises contributed to changes in or the emergence of new

international institutions also the rules and principles. New global frameworks in May 2009 act

as the main method to effectively implement the policy recommendations outlined in the G20

communiqué in London. At the present time, despite a number of objectives listed for the FSB

to carry out in collaboration with national regulators, there is no guarantee that all national

regulators comply with the objectives of the FSB. There are also challenges for the FSB to

work with all the offshore canters as a way of removing regulatory arbitrage. Furthermore, there

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is significant reliance on national authorities to ensure that international institutions can fully

discharge their global responsibility.

One of the challenges on 21st century is how to deal with global financial problems that

require global solutions for global solutions that require global ownership and global leadership.

It is importance requirement of having an effective global framework to a global financial

system and the international financial architecture especially in the 21st century. In other

words, an effective global financial system and successful implementation of the international

agreements are also essential to ensure global financial stability and sustained global

economic growth. Furthermore, dynamic interaction between the national and global economy

could instantaneously move from one country to another where less effective international

institutions could negatively affect national institutions. For example the Asian currency crisis

and the recent global financial crisis have shown, less sound and effective national institutions

could also affect the effectiveness of the international financial system. Moreover they are more

information available to international institutions which could assist national regulators to see

the global implications of some of the financial risk associated with national financial products

better. However, in the presence of more international accountability, national regulators may

well be more vigilant in the discharge of their expected responsibility.

6.3 The Effect of Current Global Financial Crisis

The global financial crisis started to show its effects in the middle of 2007 and into 2008. In fact,

since August 2007, financial markets and financial institutions all over the world have been hit

by catastrophic developments with existing of problems in performance of subprime mortgages

in the US. Around the world stock markets have fallen, the Central banks have provided

support on the order of hundreds of billions, intervening not only to support the markets but

also to prevent the breakdown of individual institutions. While the large financial institutions

have collapsed or been bought out. Lastly, the governments in even the wealthiest nations

have had to come up with rescue packages to bail out their financial systems.

Many financial institutions began to be affected, particularly those with large exposures

to subprime-related structured products, leading to a series of failures of several large US

financial institutions (Bear Stearns, American Insurance Group, Lehman Brothers, Washington

Mutual, etc.). As a result, transactions in global interbank markets began to freeze due to the

perceived rise in counterparty risks, exacerbating the liquidity problem even for healthier

financial institutions. The financial institution crisis hit its peak in September and October 2008.

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Several major institutions failed, were acquired under duress, or were subject to government

takeover. These include Lehman Brothers, Merrill Lynch, Fannie Mae, Freddie Mac,

Washington Mutual, Wachovia, Citigroup, and AIG.

The US sub-prime mortgage fall down and the breakdown of connected financial sector

technologies currently working their way through world financial markets have been interpreted

as the shock both that was caused by the system and that will finally bring the Bretton Woods II

system to its end. The Bretton Woods II system requires large and sustained investment in the

US by foreign government and individuals. It seems prudent to doubt that the required faith in

the US economy and financial system can be maintained in the face of the miserable

performance of US assets and institutions. Sharp decline in the market value of US financial

assets and a general failure of most valuation models in a widespread banking panic could

indeed threaten the Bretton Woods II or any other international monetary system.

In absolute terms, the numbers involved seem large. As of April 2008, the International

Monetary Fund (IMF) was predicting aggregate losses of 945 billion dollars overall, 565 billion

dollars in US residential real-estate lending and 495 billion dollars from repercussions of the

crisis on other securities. By October 2008, the IMF had raised its loss prediction to 1.4 trillion

dollars overall, 750 billion dollars in US residential real-estate lending and 650 billion dollars

from repercussion of the crisis on other securities. Moreover, the IMF estimated that large US

and European banks lost more than $1 trillion on toxic assets and from bad loans from January

2007 to September 2009. These loses are expected to top $2.8 trillion from 2007 until 2010.

US banks losses were forecast to hit $1 trillion and European bank losses will reach $1.6

trillion. The IMF estimated that US banks were about 60% through their losses, but British and

Euro zone banks only 40%.

The global financial crisis has impacted International Development Association (IDA)

eligible countries across the world and has prompted a strong response from the international

community. The crisis commenced in industrialized countries and spread to IDA eligible

countries which were already coping with the impact of food and oil price increases. While the

crisis reached these countries with some delay, it has caused significant income and job losses

through declining external trade, remittances, and foreign direct investment flows. The slow-

down in economic activity has reduced fiscal revenues in many countries putting core spending

at risk. In IDA only countries annual core spending needs at risk are estimated to amount to

about US$11.6 billion in 2009. Moreover, the growth rate of IDA countries is expected to drop

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from 5.4 percent in 2008 to 2.2 percent in 2009. Considering population growth in IDA

countries, these numbers imply that many countries face the prospect of stagnant or even

declining per capita incomes.

The global financial crisis in US also affected to International Finance Corporate (IFC).

IFC’s capital position was impaired by the crisis, but could have supported a moderate

countercyclical response overall. In September 2008, IFC’s balance sheet contained

substantial unrealized equity gains, and write-downs were significant ($1 billion).

Nonperforming loans were relatively low, but expected to rise. IFC had also committed to

significant grants to IDA ($1.75 billion between fiscal 2008 and 2010). Nonetheless, IFC’s

estimate that it could invest 5 percent more per year in fiscal 2009 until 2011 than in 2008 was

conservative, given a rating agency assessment that IFC was well capitalized and experience

that showed gains in investing counter cyclically during a crisis. Ultimately, IFC investments fell

nearly 20 percent in the first year of the crisis well below expectation.

6.4 Government responses whether the US goverment overcome or not.

Crisis that has begun with housing bubble which the dramatic collapse of housing price due to

a low interest rates that have make the criticism occur whereby the federal kept the interest

rates too low for a long period. Because of the collapse, many banks have failed and began to

liquidate their assets. Besides that, the lending markets froze and the stock market also

decline. Government has response to the crisis by reducing the federal funds rate near to zero

levels and printing more money. United States congress also has passes a financial bill namely

Dodd-Frank Wall Street Reform and Consumer Protection Act in order to protect the customers

from the unfair treatment from the financial institution. The bill will protect the consumer by

creating the Consumer Financial Protection Bureau. Consumer will get the authority to get clear

and accurate information for the mortgage, credit card and other financial product. It is also

protect the customer from hidden fees, unfair term and so on. The bill also created the

Financial Oversight Council (FSOC) and has adopted the “Volcker Rule”. FSOC can

recommend to Federal Reserve on imposing constrain and also may force the financial

companies to divest its asstes if they pose a threat to United State financial system. (Summary

of Dodd - Frank Wall Street Reform and Consumer Protection Act, 2010).

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Federal Reserve Chairman, Dr Ben Bemanke has argued that the Federal Reserve

must evaluate what have their learned in the past experience such as in the sub-prime crisis.

He has draw four major lesson in order to protect the customer from the sub-prime mortgage

crisis if it’s happen again in the future. It is including disclosures by lenders for consumers to

make informed decisions, prohibition of a abusive practice by rules, offering of principles based

guidance together with supervisor oversight and taking less formal steps whereby working with

industry participants to establish and encourage best practices or supporting counseling and

financial education for potential borrowers.

Beside that, new law also has been adopted for the sake of the investor which is

through Securities and Exchange Commission (SEC) and Commodity Futures Trading

Commission (CFTC). There are responsible for monitoring and regulating the market for all

derivatives. While, the Office of Credit Rating Agencies have been created to provide oversight

and have authority to examine and impose fines when it’s needed. These laws are response for

a failure of agencies to assign more appropriate ratings. Beside that, for the credit crunch crisis

in order to alleviate the liquidity crunch, Federal Reserve has reduce the discount rate by half a

percentage point and lengthened the lending horizon to 30 days. Bank can borrow at the

Federal discount window but they are fears to do so because it will show or give a signal that

there are lack of creditworthiness on the interbank market. But, Fed has lowered the federal

funds rate by half a percentage point. The U.K bank Northern Rock can’t afford to finance their

operation by interbank market and accept a liquidity support from Bank of England. The crisis

has become worse starting November 2007. Fed tends to cut the federal fund rate but was not

reach the bank caught in the liquidity crunch. Then, the Term Auction Facility (TAF) has been

created by the Fed where commercial bank can bid loans against a broad set of collateral and

also for a mortgage- backed securities. Its will help to resuscitate interbank lending.

7.0 Conclusion

As a conclusion, in the late 1920s, US were experienced with the Great Depression where

stock market booms. Many countries across the world were finally hit by debt and currency

crises. It also resulted in the collapse of large financial institutions, the bailout of banks by

national governments and decline in stock markets which suffered around the world. With

higher effect in some countries than others, the Great Recession has affected the whole world

economy. Within a month, the assumptions were truth and forced western governments to

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injected larger sums of capital into their banks to prevent the bank’s collapse. After a period of

high oil prices, it’s come to persuaded central banks to keep interest rates high to against

inflation rather than to cut them in anticipation of the financial crisis spreading to the real

economy. The current economy situation of United States towards the current global financial

crisis that affected entire country in the whole world with the factor of current global financial

crisis, the implication into international financial institution, the effect into International Financial

Institution and the government give responses towards the current global financial crisis and

International Financial Institution. The global financial crisis started to show its effects in the

middle of 2007 and into 2008. Since August 2007, financial markets and financial institutions all

over the world have been hit by catastrophic developments with existing of problems in

performance of subprime mortgages in the US. Many financial institutions began to be affected,

particularly those with large exposures to subprime-related structured products, leading to a

series of failures of several large US financial institutions. The financial institution crisis hit its

peak in September and October 2008. Sharp decline in the market value of US financial assets

and a general failure of most valuation models in a widespread banking panic could indeed

threaten the Bretton Woods II or any other international monetary system. The global financial

crisis has impacted International Development Association (IDA) eligible countries across the

world and has prompted a strong response from the international community. The global

financial crisis in US also affected to International Finance Corporate (IFC). Government

reducing the federal funds rate near to zero levels and printing more money to the crisis. United

States congress also has passes a financial bill namely Dodd-Frank Wall Street Reform and

Consumer Protection Act in order to protect the customers from the unfair treatment from the

financial institution. The Consumer Financial Protection Bureau create the bill to protect

customer from hidden fees, unfair term and so on. new law also has been adopted for the sake

of the investor which is through Securities and Exchange Commission (SEC) and Commodity

Futures Trading Commission (CFTC). There are responsible for monitoring and regulating the

market for all derivatives. While, the Office of Credit Rating Agencies have been created to

provide oversight and have authority to examine and impose fines when it’s needed. for the

credit crunch crisis in order to alleviate the liquidity crunch, Federal Reserve has reduce the

discount rate by half a percentage point and lengthened the lending horizon to 30 days. Bank

can borrow at the Federal discount window but they are fears to do so because it will show or

give a signal that there are lack of creditworthiness on the interbank market. But, Fed has

lowered the federal funds rate by half a percentage point. Fed tends to cut the federal fund rate

but was not reach the bank caught in the liquidity crunch. Then, the Term Auction Facility (TAF)

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has been created by the Fed where commercial bank can bid loans against a broad set of

collateral and also for a mortgage-backed securities. Its will help to resuscitate interbank

lending.

8.0 References

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and the Global Financial Crisis. Journal of International Economics. Christoffersen, P. & Errunza, V. (2000). Towards a global financial architecture: capital mobility and risk management issues. Emerging Markets Review. Vol 1, Pp 3-20 Dooley, M., Folkerts-Landau, D. & Garber, P (2008). Will subprime be a twin crisis for the United States? National Bureau of Economic Research. NBER Working Paper no. 13978, April 2008.

Dwyer, G,P,. (2009). Lothian, R.J. International and historical dimensions of the financial crisis of 2007 and 2008, Journal of International Money and Finance, Vol.31, pp. 1–9

Foo, T, C. (2008). Conceptual lessons on financial strategy following the US sub-prime crisis. The Journal of Risk Finance. Vol 9, Pp 292-302

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Gentle, C. (2008). How the credit crunch has its roots in the lack of integrated governance and control systems. The Journal of Risk Finance, Vol 9. Pp 206-210 Hellwig, M. (2009). Systemic risk in the financial sector: An analysis of the subprime-mortgage

financial crisis. De Economist, 157, no. 2, pp. 129-207

Hofstede, G. (2009). American culture and the 2008 financial crisis. European Business Review, Vol. 21 No: 4 pp. 307 – 312

International Development Association (IDA), November 23, 2009. Proposal for a pilot IDA crisis response window. IDA Resource Mobilization Department (CFPIR). Jobst, A, A. (2006). Asset securitisation as a risk management and funding tool: What small firms need to know. International Journal of Managerial Finance, Vol 32. Pp 731-760 Lee, S, S. (2012). The Current and Future Impacts of the 2007-2009 Economic Recession on the Festival and Event Industry. International Journal of Event and Festival Management. Vol 3. Pp 2-2 Lewis, S. (2009). Leading through the credit crunch. Industrial and Commercial Training, Emerald Article. Vol 41, Pp 363-367 Rapp, W.V. (2009). The Kindleberger-Aliber-Minsky paradigm and the global subprime mortgage meltdown, critical perspectives on international business, Vol. 5 No: 1/2 pp. 85 – 93

Shachmurove, Y. (2011). A historical overview of financial crises in the United States, Global

Finance Journal, Vol. 22, pp. 217-231 Thakor, V, A. (2012). Incentives to innovate and financial crisis. Journal of Financial Economics. Vol 103, Pp 130-148