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The World Financial Crisis

Essay by   •  December 26, 2018  •  Case Study  •  4,105 Words (17 Pages)  •  110 Views

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The 2008 world financial crisis

     

Lecturer: Ilia Botsvadze

     

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The 2008 world financial crisis

Many economists consider the 2008 financial crisis as the worst economic disaster after the Great Depression of 1929. It led to the great recession in global economy and even today, more than 10 years later, we can’t  exactly say how much did it cost to world economy. We will take a closer look to background, causes and final consequences of this crisis.

Some important events, which included overall deregulation for financial intermediaries by USA government and fed, creating government sponsored enterprises such as “Fannie Mae “, “Freddie Mac” and 2001 recession, created background for 2008 crisis. Deregulation refers to several acts that had a strong influence on banking system. These acts were: Gramm-leach-Bliley act and commodity futures modernization act of 2000.

The Gramm–Leach–Bliley Act is an act of the United States Congress (1999–2001). It removed limitation in the market between banking companies, securities and insurance companies that prohibited any institution from acting as any combination of an investment bank, a commercial bank, and an insurance company. President Bill Clinton was the one who signed this legislation into law. Many of the largest banks, brokerages, and insurance companies demanded the act at the time and they justified themselves with the fact that individuals usually put more money into investments when the economy is doing well, but they put most of their money into savings accounts when the economy turns bad. With the new Act, people would do both 'savings' and 'investment' at the same financial institution and these financial institutions would be able to do well in both good and bad economic times. (Jolina C. Cuaresma, 2002)

        The Commodity Futures Modernization Act of 2000 officially regulated financial securities, which are known as over-the-counter derivatives.Over-the-counter (OTC) derivatives are securities that are traded directly between two parties of this agreement, without going on a stock exchange or to other intermediaries. Contractslike swapsforward exchange rate agreementsoptions – and other  derivatives – are usually traded in this way. The OTC derivative market is mostly unregulated because the negotiation takes place between two parties; As a result, itbecame difficult to estimatevalue of the products that are traded on OTC market, because trades occur in private, unlikely to stock exchange. This act was signed into law on December 21, 2000 by President Bill Clinton and the most significant consequence of it was that it allowed financial intermediaries to trade between each other with derivatives such as credit default swaps, CDOs and others. (Colleen M. Baker, 2010)

        In 1968, U.S. Congress founded government-sponsored enterprises (GSE), Fannie Mae and Freddie Mac. Their function was to create a liquid secondary market for mortgages. This meant that financial institutions no longer had to hold the mortgage loans they lent; it was possible to sell them on the secondary market after origination. This enabled banks to sell their mortgages and then make new mortgages with that money. (Kevin R. Kosar, 2007)

        The 2001 recession has to be taken into consideration when we are talking about stage for 2008 crisis. Actually, it has its origin in 1999, because there was an economic boom in computer and technology sales. Many companies and individuals as well bought these new technologies to make sure their software were meeting contemporary requirements. High demand on them led the stock price of many high-tech companies to increase. Investors' began buying the stocks of any high tech company, whether they were profitable or not. It became apparent that this boom on technology would decline someday as companies had already bought all the equipment they would need. As a result, the stock market started to drop in March 2000. Therefore, value of these technology companies declined and they went bankrupt. The Federal Reserve ignored the situation on the market and continued raising interest rates. The fed funds rate reached 6.5 percent by May 2000 but the economy needed low rates for cheap credit.  The 11.09.2001 attack  definitely worsened the situation. Even New York Stock Exchange has been closed for four trading days after this attack. Unemployment reached almost 6% percent in December 2001. (Kevin L. Kliesen) That rate was higher than usual and the Bush administration tried to end this recession with expansionary monetary policy. Central banks around the world tried to stimulate the economy. They tried to increase liquidity in the market by lowering of interest rates. In December 2001, Federal Reserve Chairman Alan Greenspan lowered the fed funds rate to 1.75 percent in December, then nearly to 1.25 percent in 2002. (FED, 2002)

        So to sum up, at the end of 2002, commercial banks had a right to act as an investment banks, this means they could trade with every security and derivative and mortgage loan. At this time fed rate was at 1.25%, so investors wouldn’t invest in government issued securities, because they were earning too low interest, so they started to look for other, different ways to make investments. USA government gave banks opportunity to get higher and higher revenues this way, it was just necessary to come up with a way that would provide funding for more and more securities for banks to sell them. They looked for other sources, such as derivatives and exotic loans.  It was no problem to issue securities, but they should have been backed by something to attract investors. At that time, the only industry, in which prices kept rising, was the housing industry. Demand on housing was high, as American people were buying houses with mortgage loans and this fact made financial intermediaries think to back their securities with mortgages, because they were stable and safe source of income.  Therefore, the process of securitization began.

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