Research Proposal: Global Financial Crisis

Definition and Types of Crises

There are four general types of financial crisis (listed below) and many crisis situations may have elements of all of these types or only of one of them.

Currency crisis. A currency crisis occurs when there is a speculative attack on the exchange rate, that devaluates domestic currency or significantly depreciates a floating currency. A currency crisis occurred in Europe in 1992 when United Kingdom and Italy were forced to leave the ERM.

Banking crisis. A banking crisis happens when investors lose confidence in banks and withdraw their deposits that, causing a run on the banks. Banking crisis can also happen when banks make many bad loans and investments, that they become insolvent. In both cases banks are forced to close or ask government for help. The most famous banking crisis occurred in the United States in the beginning of 1930s, when more than 10,000 banks collapsed.

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Systematic financial crisis. Systematic financial crisis is a devastating disruption in financial marketing affecting the whole economy. Systematic financial crisis may involve banking and currency crises, as well as breakdown of equity and bond markets and money market institutions. Systematic financial crises happen not so often as other types of crises and usually involve a major political collapse. A systematic financial crisis happened in Serbia in 1993 and was accompanied by hyperinflation.

Foreign debt crisis. Foreign debt crisis occurs when a country is unable to keep up the interest payments on the foreign debt. This situation may trigger currency and banking crises. In such cases, countries usually ask IMF for help. This type of crisis happened very often in the modern history. A big crisis occurred in 1982 and affected many Latin American countries, including Mexico, Brazil and Argentina. The survival of many US and UK banks that have invested in these countries has been threatened.

Origins of Crises

All crises usually have common causes, which include creation of unsustainable economic imbalances in asset prices and exchange rates. Many crises have been causes by a sudden loss of confidence in a banking system.

A big financial crisis has occurred in Asia in 1997. A currency crisis has evolved into banking crisis and affected Korea, Thailand, Malaysia, the Philippines, and Indonesia. These countries have experienced several years of constant growth and were known as the success story of the world economy. The banks have made many loans, since profits were rising, as well as equity and property prices. Very few loans defaulted and bankers got too confident in the ability of borrowers to repay their loans. Many young bankers have seen only financial growth and did not expect any other conditions. Asset prices were driven up by speculators who borrowed money to buy assets, which in turn was also driving assets prices up. When an asset bubble burst, it created a chain of bankruptcies. In addition to that, good times have covered up that many banks were poorly run and that a system of banking regulations was inadequate. The financial crisis caused bankruptcies and financial problems for millions of people. Asian crisis was very similar to the current crisis and it is surprising that the Asian crisis in 1997-1998 did not teach the rest of the world a lesson.

Asian crisis did raise several questions in the rest of the world, namely whether government should control asset prices. Assets here are referred to such assets as houses and factories, as well as partially to prices of securities, including company shares. Before the crises, the main approach was that government should keep under control retail prices. It was believed that if retail prices are stable they will eventually stabilize asset prices. However, this approach did not take into account asset price bubbles. Such bubbles can cause significant damage to the economy, however, they can be prevented if necessary policies and regulations are in place.

Causes of the Current Financial Crisis

Just like before the Asian crises of the 90s, financiers, bankers and lawmakers during the last several years, became too confident in the market growth and stability. There were no financial regulations to prevent risk concentration. Macroeconomic policies did not prevent acceleration of systemic risks in the financial system and in housing market. For seven years in a raw interest rates were low and economy growth was high. Compensation is financial companies was based on short-term profit, which stimulated risk-taking. Financial institutions were not properly controlled and supervised. Everyone apparently relied on the market discipline and due diligence, which, as it turns out, has failed. The regulators did not have enough information about the risk activities of the banks. The US Government has temporally banned short selling in more than 900 financial institutions. The ban was lifted in October.

Current Credit Crisis

Credit crisis is dragging the U.S. and together with them the rest of the world into very deep recession. In the last decades the economic slow-downs were quite mild mainly because the consumer spending was more or less stable, which in turn was possible due to the numerous ways to borrow money. Since 1985, consumer personal savings were steadily declining and debt was tremendously increasing. People were spending and borrowing more and more. No one would be surprised now to see that a person has 15 credit cards.

Now the period of great spending seems to be over. Stock markets and house values have dropped and consumers spending decrease. These negative financial factors are driving out of business many companies all over the world. The firms that go out of business lay off workers, who, after losing their job, might not be able to pay their bills and file for bankruptcy.

Banks all over the world are not issuing enough credits. Many corporations are not able to obtain working capital which prevents their development. Foreign investors are especially reluctant to invest in developing countries since their economic systems are more vulnerable. Almost no securities are issued and equity prices have significantly declined.

Subprime mortgage crises

The subprime mortgage crisis is one of the main triggers of the financial crises in the United States. It started in late 2006 and caused a chain effect crisis in the financial markets worldwide throughout 2007, 2008 and 2009. The crisis began with the bursting of the US housing bubble and the big number of defaulted borrowers of “subprime” credits and other adjustable rate mortgages made to people with less income or poor credit history. The mortgage crisis expressed itself in liquidity problems in the banking system and high number of foreclosures. The loan incentives and the trend of stable price rising in the housing sector pushed the borrower to assume mortgages, thinking that later on they will be able to refinance their loans at more favorable conditions. But when the prices of the real estate started going down in 2006 – 2007, refinancing became less feasible due to the rising adjustable interest rates. Borrowers had to pay more than their property was worth. During 2007, the default rate rose with 79% compared to 2006 and around 1,3 Million properties in the United States were subject to foreclosure. The first ones to be affected were the mortgage lenders who retained the credit risk – borrowers were unable or unwilling to make the payments. Among such lenders is New Century Financial Corporation, which used to be the second lender in the country. Major banks and financial institutions suffered huge losses. “The failure of these companies has caused prices in the $6.5 trillion mortgage backed securities market to collapse, threatening broader impacts on the U.S. housing market and economy as a whole.”

Subprime lending has become a common practice in the United States during the last decades. Unfortunately, land owners very often lend their lands to people with poor credit ability. Poor credit characteristics put under doubt financial responsibility of some subprime borrowers. In these cases lenders take on risks cooperating with such borrowers. Lenders use different methods to compensate this risk. They use higher interest rate, higher over limit fees, higher yearly fees, or higher late fees as a compensation for poor credit ability. “These late fees are then charged to the account, which may drive the customer over their credit limit, resulting in over limit fees.”

The subprime mortgage crisis is the most severe real estate recession, it is far from over and it is growing drastically spreading in nearly every major US city. The prices of home decline and the number of filing for foreclosure rises with a pace unseen before. According to the S&P/Case-Shiller composite index for 20 cities the house prices tumbled 12.7% in February compared with 2007’s rate. According to the National Bureau of Economic Research this drop left around nine million people who have to pay to the lenders more that their properties are worth. This amount is 10% of the mortgage borrowers, another 6% are behind their schedule for payment. Loan providers are foreclosing on many houses amounting to more than a million. The pessimistic opinions is that the amount of defaults will rise more and more and it will exercise pressure on home prices pushing them further down. It is very likely to happen in short term whereas in long term there is light in the tunnel. The falling prices have made homes a bit more affordable, the government is also putting efforts into the ongoing real estate issue.

Even though measures were taken by the Federal government and the Federal Reserve, the forecast for declining house prices remains until the excess inventory has been gradually removed. But the problem the world economy faces is not only the mortgage market shrinking but the three-fold effect that the price deflation brings along. The first one logically is the tougher credit conditions banks require for loans which, some experts believe, should have been done long time ago. The second effect is worsening of the labor market with rising unemployment and slowing salaries. The wages in 2008 in the private sector have risen with 3.6%. This is the worst result since mid-2003. On the other hand the inflation hit a record of almost 4% for the same period which make the real pay falling. The third effect of the subprime market crisis is pushing the commodity prices high up.

The strongest impact the crisis had, was on the financial markets. A chain effect was created around the world. As already mentioned above many banks like Bank of America, Citibank, Merrill Lynch, UBS and others have written off billions of dollars. Bear Sterns Bank was bailed out by JP Morgan Chase with the support of the government. These events made the policy makers in many developed countries to undertake more aggressive actions in order to soften the disastrous impact. The first step was to provide liquidity and undertake saving operations for some troubled bank (above ex.: Bear Sterns Bank). The second step was to cut interest rates. In order the boost the economy and to stimulate investment the Currently the home prices are still going down and the sales are decreasing. The experts do not see the situation otherwise until the credit markets loosen and nobody expect encouraging financial figures from the construction companies.

The recessions are healthy for any economy and happen once in a while, however the coming recession is promising to deeper and longer than many before. My biggest fear is that the Great Depression of the 1929 soon will be known as the first Great Depression. As I said already, theoretically there is nothing wrong with recession, it is not a sign of “sick” economy, however, the unethical behavior of financial institutions that brought about this depression is really disturbing. Several big financial institutions were gambling with their investors’ money and as a result the whole world might be facing were problematic economic conditions soon. It seems like the whole financial system is falling in a domino effect.

Some experts blame American government for subsidizing house buying and making houses seem artificially more attractive. Government spent millions of money to encourage home ownership, because it thinks that people who own homes are more stable and obedient. Government thought that home owners will save more than they would do otherwise, however, home-equity loans increased spending. Government subsidies are not the main cause of the inflation, but it certainly helped it to intensify.

Government involvement

The current financial crises has caused the most severe recession since World War II. The economy is expected to decrease by 1.3% in 2009 and to start slow recovery a year after. The improvement is possible mainly due to the governments’ involvement. IMF Chief Economist Olivier Blanchard believes that by the end of 2009 the unemployment will start decreasing and growth can become positive again. According to IMF, financial sector restructuring is now the main priority for the governments. Obviously governments all over the world have to interfere to save their financial systems. Governments take various measures including interest rate cuts, capital injections, and lending guarantees to restore liquidity, revive the ailing banking system and rebuild investors’ confidence. This financial crisis has shown how interdependent many financial organizations are. If government will not support one collapsing bank, it can lead to collapse of several others. As a results, financial organizations that have taken excessive risks and have incurred incredible loses are being saved by the governments and tax-payers money. It can convey a wrong message to other organizations that will also decide to take excessive risk hoping that the government will bail them out if necessary. So far government institutions did not come up with the way how to track interdependency and interconnection of the companies in order to notice when they are too connected. In the years after the recession, policy-makers might need to concentrate on the way to decrease domino effect from financial institution’s collapse.

Financial analysts are proposing rules to regulate short selling. Many countries have already introduced some restrictions on this practice after the collapse of Lehman Brothers in 2008. Short seller benefits when the prices are decreasing. Some experts say that short selling has caused collapse of several companies and that the policies should be restricted or modified, however, there is no unanimous opinion on this matter among the regulators.

U.S central bank has cut interest rates to 1.5%. Loans are becoming more accessible with the lowering of rates, and it creates a hope that more people and businesses put money into the economy. Stock exchanges around the world reacted to the decline in rates, but not very strongly.

Virtually all of the world’s governments are now developing and take crisis measures, including collaboration with other countries to mitigate the possible effects of the economic downturn. Perhaps, it is due to the current crisis will occur soul-searching that bring together the positions of many politicians and economists. In the face of modernity such global economic crisis requires global action and concerted action by various countries. However, not everyone understands this fact continuing to swing the “boat” and risking themselves to “fall into the water”.

Crisis in Europe

Germany had a very careful housing market policy, however, it did not escape the crisis. The government now is trying to avoid using taxpayers money without punishing shareholders, but this move might be inevitable. Germany is also very reluctant to nationalize banks.

Government of Spain increased deposit guarantees, banned naked short selling, and approved measures that allow government to buy bank shares. The United Kingdom cut interest rates in October 2008, increased level of saving guaranteed. French government provided €320 billion to guarantee bank lending and temporarily banned short selling. Austria provided unlimited guarantee on bank deposits, injected €15 billions to boost bank capital, and limited amount of short selling.

Crisis in Middle East

Financial institutions in Middle East and Africa have not been as vulnerable to the financial crises as the Western world, because they are not completely integrated in the global financial system. Nevertheless, according to the World Bank, the region experiences decline in growth rates and growth in 2009 is expected to be lower than in 2008 in all countries except from Qatar and Yemen. The growth of Qatar and Yemen will be supported by increasing available natural gas resources. According to IMF, Middle Eastern economy will grow 2.5% in 2009, which is a significant decline compared to 5.9% in 2008 (See Table 1). Middle East and Africa are expected to slow down in their growth, but will not be as affected by the crisis as other developing regions, such as Eastern Europe, Central Asia, East Asia and Pacific,

In Egypt, economic growth slowed by 3.6% and unemployment rose to 8.8%. Several big construction projects sponsored by foreign investors stopped in Dubai, which resulted in significant job loss.

Countries of Middles East and Africa can be divided into four groups depending on their reaction to financial crisis:

First group consists of oil exporters, countries that are financially strong and have small population – Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and United Arab Emirates. This group is least vulnerable to the financial crisis. Despite the fact that their stock markets were in trouble during 2008, the governments managed to relax monetary policy – they provided capital and guaranteed deposits to the investors. Decline in oil prices will slow down the growth of these countries, with the exception of Qatar, whose GDP is expected to grow 29%. The growth of Saudi Arabia, Kuwait and the UAE the growth is supposed to be around zero. These countries have large financial reserves, which are expected to help get the countries over the crisis. The governments of these countries got involved on the early stages of the crisis to protect their banking systems and stock markets. They relaxed monetary policy, secured deposits and provided new capital where it was needed. Government of Saudi Arabia introduced a significant investment spending plan and gave capital to Saudi Credit bank to secure credits to people with low income.

Second group of countries are also oil exporters, but with relatively large populations – Algeria, Iraq, Iran, Libya and Syria. These countries have entered the crisis with less financial reserves. Iran’s government is using fiscal contraction measures and Algeria is drawing down the reserves.

Third group consists of countries that do not export oil – Jordan, Lebanon, Yemen and Djibouti. Lebanon and Jordan depend on tourism and foreign financial aid, both of which have declined. Migrant workers are returning to the countries, which will increase unemployment rate and government will face some difficulties. Jordan announced fiscal stimulus package and guaranteed deposits in the domestic banks. Despite forecasts, Lebanon did surprisingly good in 2008 – its GDP grew 9%. The number of tourists in the first three months of 2009 has increased 50% compared with the previous year. The property prices remain steady. The economic growth and stability is surprising taking into account country’s turbulent political situation. Four years ago, head of the Lebanese central bank prohibited dealing in mortgage-linked securities. Iran and some other reach Gulf countries have provided significant financial aid to Lebanon after its war with Israel in 2006. Lebanon still has huge national debt which is equal to 162% of its GDP, so country still has a long way to go in order to improve its financial situation.

Forth group consists of countries that heavily rely on tourism from Europe – Morocco, Tunisia and Egypt. These countries have already experienced decline of numbers of tourists and worsening of economic conditions. Egypt created a fiscal stimulus package directed to create new jobs and improve infrastructure. Tunisian government is taking measures to increase employment rate.
Auguste Kouame, Acting Chief Economist for the MENA Region suggests that countries in Middle East should change their social security policies and create social support programs for the parts of population that have suffered the most from the crisis. Social benefit programs will help economy to recover faster. It is important to support employment and develop infrastructure.

Eastern Europe and Central Asia

Unlike Middle East, Eastern Europe and Central Asia were hit really hard by the crisis. After several years of growth, financial crisis brought millions people in this region back to poverty. According to the World Bank, by the end of 2010, 35 million people will live in poverty or slightly above it. Albania, Moldova and Tajikistan have been hit especially hard by the crisis. It is obviously imperative for the governments of the Region to meet the urgent and immediate needs of their citizens,” said Shigeo Katsu, World Bank Vice President for the Europe and Central Asia Region. “Safety net programs – school feeding programs, nutrition, conditional cash transfer projects, cash for work – are important not only in times of crisis, but in the long-run they help to protect the poor and allow governments to avoid other more costly or inefficient policies. And if programs are well targeted, you do not need exorbitant amounts to protect the poor. Their cost – at less than one percent of GDP – can go a long way and is a small price to pay.”

Among Eastern European countries, Poland is relatively better of than its neighbors. It has received a $20.5 billion credit from the IMF. But for Poland it was not a bail-out like for Ukraine, Hungary and Latvia. It was a precautionary measure and money were offered only to top borrowers. Polish central bank has ct interest rates from 6% to 3.75%. Polish consumers have relatively fast wage growth and low level of debt, which makes them spending more. Nevertheless, the country faces serious problems: migrant workers are returning from Western Europe which drove unemployment to 11.2%. Polish government is more stable than many others in Eastern Europe. An asset-price bubble has already occurred in Poland several years ago and government has taken necessary measures to prevent it from happening again. Bank regulations have restrained borrowing in foreign currency. Compared to the neighbors in the region, Polish politic and economy looks relatively stable and plans to introduce euro in 2012-2015.

Legal Responses

Experts are predicting growing number of civil and criminal lawsuits as a result of the financial crisis. For example, recently there was a billion-dollar lawsuit filed against KPMG, one of the four biggest auditing companies. The claim of the lawsuit is that KPMG’s negligent audits helped cause the collapse of the largest subprime mortgage provider in the United States. New Century Financial Corporation has filed for bankruptcy two years ago and triggered collapse of other firms and banks, which suffered losses from mortgage-linked securities. Debtors of New Century Financial Corporation accuse KMPG in covering up problems of the company, its accounting and financial errors.

In 2008, there was a lawsuit against Merrill Lynch because the terms of its acquisition of Bank of America were unfair. AIG was sued for losses of pension. However, it is not going to be easy to satisfy all the claims, since many companies are filing for bankruptcy, like, for example, Lehman Brothers. All the lawsuits against this company are frozen and funds to pay the claims will be limited. Getting money out of nationalized companies, such as Fannie Mae, Freddie Mac and AIG will be also not easy. Lawyers are also planning to press charges against rating agencies that approved many questionable operations.

Accusations of executive excess, accounting fraud and lack of disclosure are very popular now. Significant amount of information is becoming public very fast and it becomes easier to find someone to blame. Shareholders and debtors can pursue even companies that incurred significant losses because of their liability insurance. Shareholders have files lawsuits not only against the corporations, but against directors and officers. Rating agencies are blamed for not spotting the subprime crisis. City of Baltimore pressed charges against Wells Fargo bank N.A. for targeting mainly African-American customers in their subprime lending activities.

Many experts argue that the crisis was foreseeable and this notion promises much new litigations. There appeared a new area of law – financial crisis law. Law firms are creating financial crisis to help the customers manage their financial difficulties.

Some financial observers argue that corporations are using their power and influence to prevent government from passing new regulations and necessary reforms.

Many questions remain unanswered still, for example, should there be new laws to prevent institutions to become too big to fail? Should existing large corporations be split up? I my opinion, given the current global financial environment, there should be big corporations. However, the regulations how to monitor such big corporations should change.

European Parliament is working now on the new legislature that is supposed to improve risk management and help avoiding financial crisis in the future.

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