FINANCIAL CRISIS AND ITS IMPACT

2014FINANCIAL CRISIS AND ITS IMPACTEconomics Assignment

Akash VermaManish meenaMBA(General)Section B

ACKNOWLEDGEMENT

Apart from our efforts, the success of this work depends largely on the encouragement and guidelines of many others. We take this opportunity to express our gratitude to the people who have been instrumental in the successful completion of this work. We are thankful for their aspiring guidance, invaluably constructive criticism and friendly advice during the assignment work.We are highly indebted to UNIVERSITY BUSINESS SCHOOL, CHANDIGARH for giving us an opportunity to carry out our assignment on FINANCIAL CRISIS AND ITS IMPACT at their esteemed organization. We would like to show our greatest appreciation to DR. TILAK RAJ, for giving us time and guidance, without whom it would have been impossible to attain success. We would also like to thank the people who provided us with the facilities for the assignment like the library staff. This assignment would not have been a success without the help of all the people mentioned above.We would also like to thank each other as team members as we worked together and our combined efforts lead to the completion of the project.

Akash Verma Manish Meena

Table of Contents

Introduction1Literature Review4Definition of Concepts Involved5Objective6 Origin6 What caused the crisis6Bank rescue of 20081Impact on Europe and India4Europe and the Financial Crisis5India and the financial crisis6Data diagrams & analysis4 US public debt ceiling since 19815Subprime origination Volume6 World GDP & Global Trade6 Unemployment Rates in US & Europe6 Quarterly change in GDP6Conclusion1Bibliography1

SUMMARY

This report is a fruit of thorough research on the subject of Subprime mortgage crisis of 2008. Illustrations, charts, figures, data, tables and references that are used in this report will help us to construe whether the financial crisis of 2008 could have been averted or was it inevitable.All the significant changes that occurred in the US economy due to the financial crisis of 2008 have been incorporated in this report .The report comprises of the causes and impacts of financial crisis of 2008 on the economy of the Europe and India. All these issues have been stated section-wise for its easy identification and indexing.The study is based on diverse source materials consisting mainly of text books, articles, records of various Commissions and Committees, journals and the visual media.Figures have been also included in order to explain the effects of financial crisis on the employment rate, GDP growth, Global trade level and housing price graph pre and post this financial fiasco.We are thus confident to present this report. We have been immensely benefitted by the work of various economists in this area.

INTRODUCTION

In 2008, the world economy faced its most dangerouscrisis, since theGreat Depression of the 1930s. The contagion, which began in 2007 when sky-high home prices in theUnited States finally turned decisively downward, spread quickly, first to the entire U.S. financial sector and then to financialmarkets overseas. The casualties in the United States included :- a) the entire investmentbanking industry b) the biggest insurance company c) the two enterprises chartered by the government to facilitate mortgage lending d) the largest mortgage lender e) the largest savings and loan f) two of the largest commercial banks.The carnage was not limited to the financial sector, however, as companies that normally rely on credit suffered heavily. The American auto industry, which pleaded for a federal bailout, found itself at the edge of an abyss. Still more ominously, banks, trusting no one to pay them back, simply stopped making the loans that most businesses need to regulate their cash flows and without which they cannot do business. Share prices plunged throughout the worldtheDow Jones Industrial Average in the U.S. lost 33.8% of its value in 2008and by the end of the year, a deeprecession had enveloped most of the globe. In December theNational Bureau of Economic Research, the private group recognized as the official arbiter of such things, determined that a recession had begun in the United States in December 2007, which made this already the third longest recession in the U.S. since World War II.Each in its own way, economies abroad marched to the American drummer. By the end of the year, Germany,Japan, andChina were locked in recession, as were many smaller countries. Many in Europe paid the price for having dabbled in Americanreal estate securities. Japan and China largely avoided that pitfall, but their export-oriented manufacturers suffered as recessions in their major marketsthe U.S. and Europecut deep into demand for their products. Less-developed countries likewise lost markets abroad, and their foreign investment, on which they had depended for growth capital, withered. With none of the biggest economies prospering, there was no obvious engine to pull the world out of its recession, and both government and private economists predicted a rough recovery.

LITERATURE REVIEW

DEFINITIONS OF CONCEPTS INVOLVEDSecuritizationThe process through which an issuer creates a financial instrument by combining other financial assets and then marketing different tiers of the repackaged instruments to investors. The process can encompass any type of financial asset and promotes liquidity in the marketplace.Mortgage-backed securities are a perfect example of securitization. By combining mortgages into one large pool, the issuer can divide the large pool into smaller pieces based on each individual mortgage's inherent risk of default and then sell those smaller pieces to investors.

The process creates liquidity by enabling smaller investors to purchase shares in a larger asset pool. Using the mortgage-backed security example, individual retail investors are able to purchase portions of a mortgage as a type of bond. Subprime MortgageA type of mortgage that is normally made out to borrowers with lower credit ratings. As a result of the borrower's lowered credit rating, a conventional mortgage is not offered because the lender views the borrower as having a larger-than-average risk of defaulting on the loan. Lending institutions often charge interest on subprime mortgages at a rate that is higher than a conventional mortgage in order to compensate themselves for carrying more risk. Borrowers with credit ratings below 600 often will be stuck with subprime mortgages and the higher interest rates that go with those mortgages. Making late bill payments or declaring personal bankruptcy could very well land borrowers in a situation where they can only qualify for a subprime mortgage. Therefore, it is often useful for people with low credit scores to wait for a period of time and build up their scores before applying for mortgages to ensure they are eligible for a conventional mortgage. Bailout packageA situation in which a business, individual or government offers money to a failing business in order to prevent the consequences that arise from a business's downfall. Bailouts can take the form of loans, bonds, stocks or cash. They may or may not require reimbursement. Bailouts have traditionally occurred in industries or businesses that may be perceived as no longer being viable, or are just sustaining huge losses. Typically, these companies employ a large number of people, leading some people to believe that the economy would be unable to sustain such a huge jump in unemployment if the business folded.For example, Chrysler, a large U.S. automaker was in need of a bailout in the early 1980s. The U.S. government stepped in and offered roughly $1.2 billion to the failing company. Chrysler was able to pay the entire bailout back, and is currently a profitable firm.

OBJECTIVEThe study was conducted keeping in mind the following two broad objectives:-1. To study the causes and consequences of financial crisis of 2008.2. To research what should we do in order to prevent it from happening again.

ORIGINWhat is the credit crisis?It is a worldwide financial fiasco involving terms you have probably heard like subprime mortgages, collateralized debt obligations, frozen credit markets and credit default swaps.Who is affected by this credit crisis?It is everyone, here is how. The credit crisis brings two types of people together- homeowners and investors. Homeowners represented mortgages and investors represent their money. These mortgages represent houses and money represented the large institutions like pension funds insurance company sovereign funds etc.These groups are brought together through the financial systems that is a bunch of banks and brokers which are commonly known as the Wall Street. Well it may not seem like this but these banks on the Wall Street are connected to the houses on the main street. Let us understand how and in order to understand how let's start from the beginning.Many years ago investors were sitting on their pile of money looking for investment so that they can earn more money. Traditionally, they will go to the US Federal Reserve where they will buy the treasury bills. But in the wake of the dot-com bubble in the late nineties the US federal chairman Alan Greenspan lowered the interest rates to 1 % in order to keep the economy strong. 1 % is a very low return on investment, so that's why the investor didn't invest in US treasury bills.On the other hand, the banks on Wall Street can borrow from the Federal Reserve at the rate of just 1 % and it was supplemented by additional surpluses from Japan, China and Middle East so there was an abundance of cheap credit which made borrowing money easy for bank which made them go easy with leverage. What is leverage? Leverage is borrowing money to amplify the outcome of a deal. For example in a normal deal someone with 10000 dollar will buyup box worth 10,000 dollar and he will sell it to someone else at let's suppose 11000 dollar making a profit of 1000 dollar which is a good deal. But using leverage, someone with 10000 dollars would go borrow 9,90,000 dollars which will give him 1 million dollars in hand then he goes and buys 100 boxes with 1 million dollars and sells it to someone else for 1,100,000 dollars then he pays back his 9,90,000 dollars + 10000 dollars interest. And after subtracting his initial 10000 dollars he is left with 90,000 dollars. This is phenomenal as compared to the first case in which the profit was 1000 dollars. Thus leverage turns good deals into great deals.

This is the major way why the banks make the money so that Wall Street takes out at ton of credit from the banks. Wall Street then makes a great deal and grows tremendously rich and then it pays it back. The investors too want to join in and make huge profits. In this case, Wall Street gets an idea that they can connect investors to the homeowners through mortgage risk.

WHAT CAUSED THE CRISIS?Now let's get on to the mortgage problem. A family wants a house so they decide to take a loan that can be repaid in down payment. Family contacts the mortgage broker. The mortgage broker connects the family to the lender who gives the mortgage loan. The broker makes a nice commission and the family becomes the homeowners. This is a win-win situation for both family and the mortgage broker because the house prices have been rising since forever. And with increase in prices the demand of the property increases too, making brokers business flourishing.One day the lender gets the call from the investment banker who wants to buy the mortgage. The lender sells it to him for a very nice fee. The investment banker then borrows millions of dollars and by myriad such mortgages and combines them into a box. This box means the combined mortgages of all the issues. This means that the investment banker will get money regularly from the family as the down payment. This box is then converted into a financial instrument called collateralized debt obligation and rated into three categories safe, ok and risky. Here risky means that you will get a higher rate of return whereas the safe will receive low return, but still it will be better than the US federals return and the bank insures this safe slice for small fees called credit default swap. The credit agencies rate the safe as AAA. This is the safest rating present. Ok is rated as BBB which is moderately good. But the credit agencies do not bother to rate the risky ones. The investment bankers sell the safe slice to the investors who want to invest in a safe investment.

The risky one is sold to the hedge funds and other risk takers. The investment banker makes millions and then repays his loans. Finally, the investor has found a better investment than the Federal Reserve investments. So, in greed they want more CDO slices so the investment banker calls the lender wanting more mortgages. The lender call up the broker asking him to bring more homeowners but the broker cant find anyone. Everyone who qualifies for the mortgages already has one. Now they come up with an idea, when the homeowners default on the mortgages the house becomes the property of the lenders and as the house rates are always going up this makes them believe that they are covered to take more risk. So, the lender starts adding risk to the new mortgages.Since they are covered if the homeowner defaults lenders can start adding risk to new mortgages by providing loans to people who cannot afford down payment, have no proof of income and no documents at all. These loans were basically called NINA loans i.e. no income no asset loans. That's exactly what that happened. So, instead of lending to the responsible homeowners call prime mortgages they started lending to somewhat irresponsible homeowners called subprime mortgages. This was the turning point. So just like always a mortgage broker connect the family to the lender, Family buys a big house. The lender sells the mortgages toinvestment banker and he turns it into a CDO and sells slices to the investor and others. This actually works out nicely for everyone and makes them all rich. No one was worried because as soon as the mortgages were sold to the next link in the chain it was not their problem. If the homeowners were to default, it was not lenders problem as they have passed on the risk to the investment bankers. Not surprisingly the homeowners started defaulting on the loans. This means that the banker forecloses one of his monthly payments and it turns it into a house. He puts it up for sale. But when more people started defaulting on the mortgages, more and more of his down payment started getting converting into the houses. Now there were so many houses on the market that supply exceeded demand. Eventually house prices started plummeting. As it can be seen in the graph that house prices were on a rise since 1900, but in around 2008 the prices eventually took a downward turn.

This created an interesting problem for responsible homeowners who were still paying the down payment. As all the houses in the neighborhood went up for sale the value of even their houses went down and they started to wonder why they were paying higher mortgages for an undervalued asset. They decided that it doesn't make sense to keep paying even though they can afford to pay the down payment of their house. The situation became disastrous as both prime and subprime mortgages started defaulting and prices plummeted even more now. The investment banker is holding onto the CDO which is nothing but worthless houses. He calls up his party, the investor, to buy CDO but the investor is not stupid. The investor declines the offer. The banker tries to sell it to everyone but everyone declines the offer. The situation becomes worse because the banker has borrowed a lot of money to buy these CDOs and he cannot pay them back. But he was not the only one as the investors have already bought thousands of CDOs. Lender calls the banker trying to sell his mortgages but the banker wont foot the bill. And the broker is out of work. Whole financial system is frozen and situation becomes dark. All of them started going bankrupt the, homeowners whose house was nothing worth they paid for, the lender who was holding onto thousands of mortgages could not bear the losses, the investment bankers who had bought the mortgages were converted into houses which were worth less and the investors who had bought bonds in the form of CDOs which won't give them any return. Thus the whole financial system was on the verge of collapse and the GDP was now growing negatively. You can begin to see how the crisis flows up in a cycle.

It was an economic 9/11 which took down major institutions like lehman brothers and AIG. On September 15th2008, giant bank lehman brothers went bankrupt due to its monumental bets on real estates. AIG, the largest insurance company in the world collapsed the very next day. Suddenly, the banks stopped giving loans to any company or each other. Experts warned that the economy is about to collapse.

Bank Rescue of 2008

In order to prevent the financial fiasco George W Bush declared that the government will put 700 billion dollar of US taxpayers money in order to buy the troubled assets that are clogging the system. This is worldwide known as the bailout package.Officially called the Emergency Economic Stabilization Act of 2008, this bailout bill surpassed any previous government bailout by hundreds of billions of dollars. It also marked the fourth time in 2008 that the government interceded to prevent the ruin of a private enterprise on the entire financial sector.In short the government spend huge amount of money to cover the bad deals in the bank. Even the banks whodid not want money were forced to take money so that public didnt come know which banks were about to collapse. The federal reserve cut down its interest rate to the lowest level ever.These steps were good enough to bring America out of this imbroglio but they was not good enough to stimulate the economy of America.On February 72009 Obama approved stimulus package worth 787 billion dollars in order to stimulate the economy of America. US politicians have spent close to 1 trillion dollars till now in order to stimulate the economy of America.

IMPACT ON EUROPE AND INDIA

EUROPE AND THE FINANCIAL CRISISEurope is facing one of the worst financial crisis ina generation. In Europe, a number of major financial institutions failed. Others needed rescuing. For example in Iceland, where the economy was very dependent on the finance sector, economic problems have hit them hard. The banking system virtually collapsed and the government had to borrow from the IMF and other neighbors to try and rescue the economy. In the end, public dissatisfaction at the way the government was handling the crisis meant the Iceland government fell.

It all started in 2007 in the United States where over optimistic banks went bankrupt because of bad lending in the mortgage market. In September2008, the world's fourth largest bank lehman brothers collapsed. The crisis has since spread to the rest of the world, vicious circle developed, banks stopped lending to each other and the credit dried up in order to prevent the lapses of the banking system. European governments came to the rescue of the banks with urgent support on an unprecedented scale. A number of European countries have attempted different measures (as they seemed to have failed to come up with a united response). 4.5 trillion euros which is equivalent to 37 % of the annual GDP were committed between 2008 and 2011. European Union also launched a your wide recovery program to safeguard jobs and social protection level in order to protect economic investment. In this way the bankruptcy was avoided and the European savings were protected. The euro broadly maintained its value and successfully shielded European countries from the worst effect of economic crisis by providing stable playing field to European companies for international trade and investment. But this effort took its toll especially since the most of the money had to be borrowed. From late 2009, the most exposed European zone countries begun to have problem financing their debts leading to a new problem called Sovereign Debt Crisis. With increasing deficits and spiraling debt the markets lost confidence in governments ability to pay back what they owed. Interest rates on government bonds soon became unsustainable and since many of these European bonds were held by other European countries and banks. This turned into a problem for the whole Europe, especially for the countries which shared euro as their common currency. This loss of confidence forced the banks to reduce lending to businesses and private households. In 2009, the European union economies suffered its worst financial recession since its creation. After a brief recovery in 2012 it again went into a mild recession. As a result unemployment reached unprecedented levels creating hardships and increasing the poverty levels for the common people.

INDIA AND THE FINANCIAL CRISISIndia had higher degree of financial integration then trade integration with capital inflows both in current and capital account more than hundred percent of gdp. The crisis did impact India as well as other asian economies like china with slow down in the growth but not contraction of output, in all these economies. The impact was there but less intense than that experienced by the US and European economies. As said earlier this was the financial sector crisis and the Indian financial system was less affected given the dominance of the public sector banks which are less exposed to the complex risk products not over leveraged, failure risk averse and not much exposure to international markets and products. What the crisis did to India was to push the domestic financial sector into a conscious and wait and watch mode. It did impact some of the private and foreign banks in India but not to the same magnitude; as such exposures were limited and small in relation to their balance sheet size. The forced tightening of the liquidity by banks, self-imposed, in their own wisdom, dried up money with industrial sector which in any case had also gone in the cautious mode. Both these resulted in building up of inventories, longer production and repayment cycle and slow down of industrial and overall growth of the Indian economy. It can be said that the banking sector was on the verge of witnessing default and build-up of the bad loan book, both of which could have compound the problem manifold and the impact far greater.But the financial sector was fortunate to have a limited impact in the sense that no bank on any financial institutions collapsed. But it did dent the exports as for the first time in over a decade or so, there was contraction of exports.

But this contraction was not sufficient to contract overall output given the relative low share export in the total output of Indian economy. So, overall the impact on India was that it put in the mind of the people fear and uncertainty resulting in slow down and definitely impacting exports for a short period of six months. The impact in fallout could have been greater and deeper both for the world economy and India if there was no timely and collective government intervention by Indian government and RBI.Some of the steps taken by Indian government, with the help of RBI, in order to minimize the effects of financial crisis on Indian economy were :-1. RBI allowing banks to restructure their loan accounts, reschedule loan installments, as preventive measures to prevent build up of bad loans.2. It also went for Quantitative easing by lowering CRR, to improve liquidity.3. It advised banks to shed their risk averseness, as it was a problem not a solution, to the slowdown in the economy.4. It also ran up a high fiscal deficit by increasing spending in the economy, even at the risk of inflationary pressures and compromising on the compulsions under the FRBM |act. In fact, India ran the highest fiscal deficit in the last 16 years.5. Export concessions were extended and new strategies of incentives were given to diversify to Afro Asian countries impacted lesser by the crisisOverall, it was a combination of all, which limited the impact, without the need for any bailout as no financial institution had collapsed.

DATA DIAGRAMS & ANALYSIS

Figure 1: Showing the Debt taken by US govt has been increasing since 1981

SUBPRIME ORIGINATION VOLUME

Figure 2 :- Showing the origin and rate of increase in subprime mortgage volumes.

WORLD GDP & GLOBAL TRADE

Figure 2 :- Showing sudden decrease in global GDP during financial crisis

Figure 3:- Unemployment rate across US and Europe during & after crisis.

Figure 4 :- Showing abnormal unemployment rates in some of the European countries

QUARTERLY CHANGES IN GDP(ANNUALIZED)

Figure 5 :- Showing the change in gdp across top world countries.

CONCLUSIONS

All the measures that have been taken to save the US economy- the low interest rates, the massive debts, the safety net for the financial industry - the very things that led to the crisis in the first place. We have been saved by the consequences of one bubble buy inflating another hundred new bubbles all over the world. The u s government has launched bailout stimulus packages and guarantees to the tune of 10,000 billion dollars, which is much more than the cost of the Vietnam war, world war 1, world war 2, the invasion of Iraq and the NASAs martial plan. Loans are given by the governments of different countries at a very low interest rate in order to contain the financial crisis but this is aggravating the situation even more. As said by Raghuram Rajan, in his interview at St. Gyllian Symposium that the government will have to start raising rates in order to improve the efficiency of the economic system. But increasing the rates now will create more and more pressure on the government as they will have to shell out huge amount of money in order to pay back their debts. For example if the US government increases the rate by 1 % it will increase the US interest payments by 100 billion dollars per year. Even the illustrious credit rating institutes like S&P, Moody have lost the ingrained trust in them because of the high rating given by them to the CDOs were undermined by their defaults. But the question that needs an answer now is how will the world react if the next entity to declare bankruptcy is a nation and who is next in line if that were to happen. The government could save the banks but who will save the government. Some countries have already started falling for example in Iceland which was until recently one of the richest countries in the world but when the crisis hit Iceland, the Icelands banks collapsed, Icelands stock market crashed, leaving the debt to the small population. When the next bubble bursts we cannot use the same emergency measures i.e. can't lower the interest rates that are already hitting rock bottom, cannot stimulate the economy with the borrowed money if the excessive national debt is the cost of the crisis. We need is a strong financial framework that is free of greed and the regulatory measures that concentrate on the long term goal and objectives.

BIBLIOGRAPHY

1. Johan Norberg(2009). Financial Fiasco. Masscheutes, Washington : Cato Institute2. Raghuram G. Rajan(2010). Fault Lines. Princeton, New jersey : Princeton University Press.3. Allen, F., A. Babus, and E. Carletti (2009). Financial Crises: Theory and Evidence Annual Review of Financial Economics 1, 88.4. Nikola Kojucharov, Clyde F. Martin, Robert F. Martin, Lili Xu(2008). The subprime mortgage crisis, Journal of Housing Economics, 45.5. http://en.wikipedia.org/wiki/Great_Recession6. http://www.britannica.com/EBchecked/topic/1484264/The-Financial-Crisis-of-2008-Year-In-Review-20087. http://www.investopedia.com/8. FERGUSON, C. H., et al. (2011). Inside job. Culver City, Calif, Sony Pictures Home Entertainment.University Business SchoolPage 4