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2008 Financial Crisis

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R Hilby

on 22 August 2013

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Transcript of 2008 Financial Crisis

Definition: "the trust which allows one party to provide resources to another party in financial term"(generates debt)

Credit Crunch: reduction in the general availability of credit

Credit Agencies during the Financial Crisis
Rise in price of housing in US attracted foreign banks to invest
Mortgages backing securities fell in value --> value of securities dropped
Credit became scarce; lack of confidence in US financial institutions
2008 Financial Crisis
Low interest rates
Sub-Prime Mortgages
Definition: The reduction of debt
measured by the ratio of total debt to GDP
Impact Abroad
International Dimension
Global Policy Responses
Years leading up to crisis
Sub-prime mortgages
International Dimension
US Policies
Private sector: Consume less + save more
Government: Increase spending + cut taxes (fiscal expansion: G T )
Financial institutions: Sell assets + reduce dependency on short-term liabilities
Methods of Debt Reduction
Fiscal Stimulus Packages
Bailouts - "too big to fail"
Auto industry investment
Credit Easing
Reduce i to spur I, increase liquidity
Expansion of central bank assets
Tax cuts
Increase household income to spur I and D
Trickle down economics
Many Western countries implemented similar policies
China's Policies
Fiscal stimulus
2008 - 4 trillion Yuen
social works, infrastructure - raise G
Tax cuts, increased export rebates
aimed at building greater domestic D
Projected future positive effects
Increased domestic D, lower CA surplus
Australia and Iceland successfully implemented similar policies
Specific US Policies
Global Policy Responses
Central Bank liquidity measures
Monetary and Fiscal Stimulus Packages
Unconventional Policies
Effectiveness varies across countries
After Lehman's Failure
Credit was tightened for large banks, especially those with worse performance.

But the credit market was not frozen.
The crucial factor for 2008 financial crisis
A type of mortgage that is normally made out to borrowers with lower credit ratings.
Lenders charge interest at a rate that is higher than a
conventional mortgage

to compensate themselves for carrying more risk
Who is to blame
The Lenders
Diversifying risk and getting a larger goup of investors involved in lending to households or firms.
MBS:mortgage-based security.
CDOs: collateralized debt obligations. For example, senior securities, which have first claims on the returns, and junior securities, which come after and pay only if something is left after the senior securities have been paid.
In recession, these assets became toxic assets.

Hedge funds
Pushing rates lower, fueling market volatility

Investment Banks
Created secondary mortgages
Instead of holding the original mortgages on their books, lenders were able to simply sell off the mortgages in the secondary market and collect the originating fees.

Lehman brothers: largest victim of the U.S. subprime mortgage.

Underwrote more mortgage-backed securities than any other firm.

Increased housing demand drove up housing prices in the early 2000s, and started to fall sharply in 2006

Subprime mortgages became prevalent in 2000s, and by 2006, about 20% of all U.S. mortgages were subprime.
When housing prices plunged, many borrowers found themselves in a situation where the mortgage exceeded the value of the house. In this situation, a mortgage is said to be "underwater".
Troubled Asset Relief Program (TARP)
Treasury insurance program
Fed bailout
Treasury Insurance
Announced $50b program to insure investments

Similar to FDIC program

Intended to prevent a bank run
Signed into law October 3rd, 2008

Provided $700b for buying troubled mortgage assets

First half spent to buy preferred stock instead
Fed bailout
$800b to buy debt and mortgage-backed securities

Loans to securities backed by consumer loans
Crisis spread globally through both financial and trade linkages
Europe- Germany, France, Britain, Italy, Iceland, Ireland
Asia- China, Japan, Korea

Financial linkages
Trade Linkages
Economic downturn in US led to declining US imports from major trading partners--European Union, Mexico, China
Export sales weakened-->foreign GDPs fell
Credit Risk
Sub-Prime mortgages and credit allowed consumers and financial instiutions to accept more debt than they could handle
Credit defaults created a worldwide crisis
Countries utilized conventional and unconventional policies to spur economic activity
Full transcript