Late-2000s financial crisis - AbsoluteAstronomy.com

The late-2000s financial crisis (often called the Global Recession, Global Financial Crisis or the Credit Crunch) is considered by many economists to be the worst financial crisis

Financial crisis

The term financial crisis is applied broadly to a variety of situations in which some financial institutions or assets suddenly lose a large part of their value. In the 19th and early 20th centuries, many financial crises were associated with banking panics, and many recessions coincided with these...

since the Great Depression

Great Depression

The Great Depression was a severe worldwide economic depression in the decade preceding World War II. The timing of the Great Depression varied across nations, but in most countries it started in about 1929 and lasted until the late 1930s or early 1940s...

of the 1930s. It resulted in the collapse of large financial institutions, the bailout of banks by national governments, and downturns in stock markets around the world. In many areas, the housing market had also suffered, resulting in numerous eviction

Eviction

How you doing???? Eviction is the removal of a tenant from rental property by the landlord. Depending on the laws of the jurisdiction, eviction may also be known as unlawful detainer, summary possession, summary dispossess, forcible detainer, ejectment, and repossession, among other terms...

s, foreclosure

Foreclosure

Foreclosure is the legal process by which a mortgage lender , or other lien holder, obtains a termination of a mortgage borrower 's equitable right of redemption, either by court order or by operation of law...

s and prolonged unemployment. It contributed to the failure of key businesses, declines in consumer wealth estimated in the trillions of U.S. dollars

United States dollar

The United States dollar , also referred to as the American dollar, is the official currency of the United States of America. It is divided into 100 smaller units called cents or pennies....

, and a significant decline in economic activity, leading to a severe global economic recession in 2008.

The financial crisis was triggered by a complex interplay of valuation and liquidity problems in the United States

United States

The United States of America is a federal constitutional republic comprising fifty states and a federal district...

banking system in 2008. The collapse of the U.S. housing bubble, which peaked in 2007, caused the values of securities

Security (finance)

A security is generally a fungible, negotiable financial instrument representing financial value. Securities are broadly categorized into:* debt securities ,* equity securities, e.g., common stocks; and,...

tied to U.S. real estate pricing

Real estate pricing

Real estate pricing deals with the valuation of real estate and all the standard methods of determining the price of fixed assets apply....

to plummet, damaging financial institutions globally. Questions regarding bank solvency

Solvency

Solvency, in finance or business, is the degree to which the current assets of an individual or entity exceed the current liabilities of that individual or entity. Solvency can also be described as the ability of a corporation to meet its long-term fixed expenses and to accomplish long-term...

, declines in credit availability and damaged investor confidence had an impact on global stock market

Stock market

A stock market or equity market is a public entity for the trading of company stock and derivatives at an agreed price; these are securities listed on a stock exchange as well as those only traded privately.The size of the world stock market was estimated at about $36.6 trillion...

s, where securities suffered large losses during 2008 and early 2009. Economies worldwide slowed during this period, as credit tightened and international trade declined. Governments and central bank

Central bank

A central bank, reserve bank, or monetary authority is a public institution that usually issues the currency, regulates the money supply, and controls the interest rates in a country. Central banks often also oversee the commercial banking system of their respective countries...

s responded with unprecedented fiscal stimulus

Fiscal policy

In economics and political science, fiscal policy is the use of government expenditure and revenue collection to influence the economy....

, monetary policy

Monetary policy

Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability. The official goals usually include relatively stable prices and low unemployment...

expansion and institutional bailouts. Although there have been aftershocks, the financial crisis itself ended sometime between late-2008 and mid-2009.

While many causes for the financial crisis have been suggested, with varying weight assigned by experts, the United States Senate issuing the Levin–Coburn Report found "that the crisis was not a natural disaster, but the result of high risk, complex financial products; undisclosed conflicts of interest; and the failure of regulators, the credit rating agencies, and the market itself to rein in the excesses of Wall Street."

Critics argued that credit rating agencies

Credit rating agency

A Credit rating agency is a company that assigns credit ratings for issuers of certain types of debt obligations as well as the debt instruments themselves...

and investors failed to accurately price the risk

Financial risk

Financial risk an umbrella term for multiple types of risk associated with financing, including financial transactions that include company loans in risk of default. Risk is a term often used to imply downside risk, meaning the uncertainty of a return and the potential for financial loss...

involved with mortgage

Mortgage loan

A mortgage loan is a loan secured by real property through the use of a mortgage note which evidences the existence of the loan and the encumbrance of that realty through the granting of a mortgage which secures the loan...

-related financial products, and that governments did not adjust their regulatory practices to address 21st-century financial markets. The 1999 repeal

Gramm-Leach-Bliley Act

The Gramm–Leach–Bliley Act , also known as the Financial Services Modernization Act of 1999, is an act of the 106th United States Congress...

of the Glass–Steagall Act of 1933 effectively removed the separation that previously existed between Wall Street investment banks and depository banks. In response to the financial crisis, both market-based and regulatory solutions have been implemented or are under consideration.

Background

The immediate cause or trigger of the crisis was the bursting of the United States housing bubble

United States housing bubble

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, and may not yet have hit bottom as of 2011. On December 30, 2008 the...

which peaked in approximately 2005–2006. Already-rising default rates on "subprime

Subprime lending

In finance, subprime lending means making loans to people who may have difficulty maintaining the repayment schedule...

" and adjustable rate mortgage

Adjustable rate mortgage

A variable-rate mortgage, adjustable-rate mortgage , or tracker mortgage is a mortgage loan with the interest rate on the note periodically adjusted based on an index which reflects the cost to the lender of borrowing on the credit markets. The loan may be offered at the lender's standard variable...

s (ARM) began to increase quickly thereafter. As banks began to give out more loans to potential home owners, housing prices began to rise.

In the optimistic terms, 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 significantly. In many states like California, refinancing became increasingly difficult. As a result, the number of foreclosed homes also began to rise.

Steadily decreasing interest rates backed by the U.S Federal Reserve from 1982 onward and large inflows of foreign funds created easy credit conditions for a number of years prior to the crisis, fueling a housing construction boom and encouraging debt-financed consumption. The combination of easy credit and money inflow contributed to the United States housing bubble. Loans of various types (e.g., mortgage, credit card, and auto) were easy to obtain and consumers assumed an unprecedented debt load.

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

Financial innovation

There are several interpretations of the phrase financial innovation. In general, it refers to the creating and marketing of new types of securities.- Why does financial innovation occur? :...

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

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 built, a series of factors caused the financial system to both expand and become increasingly fragile, a process called financialization

Financialization

Financialization is a term sometimes used in discussions of financial capitalism which developed over several decades leading up to the 2007-2010 financial crisis, and in which financial leverage tended to override capital and financial markets tended to dominate over the traditional industrial...

. U.S. Government policy from the 1970s onward has emphasized deregulation

Deregulation

Deregulation is the removal or simplification of government rules and regulations that constrain the operation of market forces.Deregulation is the removal or simplification of government rules and regulations that constrain the operation of market forces.Deregulation is the removal or...

to encourage business, which resulted in less oversight of activities and less disclosure of information about new activities undertaken by bank

Bank

A bank is a financial institution that serves as a financial intermediary. The term "bank" may refer to one of several related types of entities:...

s and other evolving financial institutions. Thus, policymakers did not immediately recognize the increasingly important role played by financial institutions such as investment banks and hedge funds, also known as the shadow banking system

Shadow banking system

The shadow banking system is the infrastructure and practices which support financial transactions that occur beyond the reach of existing state sanctioned monitoring and regulation. It includes entities such as hedge funds, money market funds and Structured investment vehicles...

. Some experts believe these institutions had become as important as commercial (depository) banks in providing credit to the U.S. economy, but they were not subject to the same regulations.

These institutions, as well as certain regulated banks, had also assumed significant debt burdens while providing the loans described above and did not have a financial cushion sufficient to absorb large loan defaults or MBS losses. These losses impacted the ability of financial institutions to lend, slowing economic activity. Concerns regarding the stability of key financial institutions drove central banks to provide funds to encourage lending and restore faith in the commercial paper

Commercial paper

In the global money market, commercial paper is an unsecured promissory note with a fixed maturity of 1 to 270 days. Commercial Paper is a money-market security issued by large banks and corporations to get money to meet short term debt obligations , and is only backed by an issuing bank or...

markets, which are integral to funding business operations. Governments also bailed out key financial institutions and implemented economic stimulus programs, assuming significant additional financial commitments.

The U.S. Financial Crisis Inquiry Commission

Financial Crisis Inquiry Commission

The Commission reported its findings in January 2011. It concluded that "the crisis was avoidable and was caused by: Widespread failures in financial regulation, including the Federal Reserve’s failure to stem the...

reported its findings in January 2011. It concluded that "the crisis was avoidable and was caused by: Widespread failures in financial regulation, including the Federal Reserve’s failure to stem the tide of toxic mortgages; Dramatic breakdowns in corporate governance including too many financial firms acting recklessly and taking on too much risk; An explosive mix of excessive borrowing and risk by households and Wall Street that put the financial system on a collision course with crisis; Key policy makers ill prepared for the crisis, lacking a full understanding of the financial system they oversaw; and systemic breaches in accountability and ethics at all levels."

Subprime lending

Intense competition between mortgage lenders for revenue and market share, and the limited supply of creditworthy borrowers, caused mortgage lenders to relax underwriting standards and originate riskier mortgages to less creditworthy borrowers. Prior to 2003, when the mortgage securitization market was dominated by regulated and relatively conservative Government Sponsored Enterprises

Government-sponsored enterprise

A government-sponsored enterprise is a financial services corporation created by the United States Congress. Their function is to enhance the flow of credit to targeted sectors of the economy and to make those segments of the capital market more efficient and transparent...

, GSEs policed mortgage originators and maintained relatively high underwriting standards. However, as market power shifted from securitizers to originators and as intense competition from private securitizers undermined GSE power, mortgage standards declined and risky loans proliferated. The worst loans were originated in 2004-2007, the years of the most intense competition between securitizers and the lowest market share for the GSEs.

The term subprime refers to the credit quality of particular borrowers, who have weakened credit histories and a greater risk of loan default than prime borrowers. The value of U.S. subprime mortgages was estimated at $1.3 trillion as of March 2007, with over 7.5 million first-lien

Lien

In law, a lien is a form of security interest granted over an item of property to secure the payment of a debt or performance of some other obligation...

subprime mortgages outstanding.

As well as easy credit conditions, there is evidence that competitive pressures contributed to an increase in the amount of subprime lending during the years preceding the crisis. Major U.S. investment banks and government sponsored enterprises like Fannie Mae played an important role in the expansion of lending, with GSEs eventually relaxing their standards to try to catch up with the private banks.

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

United States housing bubble

.

Some long-time critics of government and the GSEs, like American Enterprise Institute

American Enterprise Institute

The American Enterprise Institute for Public Policy Research is a conservative think tank founded in 1943. Its stated mission is "to defend the principles and improve the institutions of American freedom and democratic capitalism—limited government, private enterprise, individual liberty and...

fellow

Fellow

A fellow in the broadest sense is someone who is an equal or a comrade. The term fellow is also used to describe a person, particularly by those in the upper social classes. It is most often used in an academic context: a fellow is often part of an elite group of learned people who are awarded...

Peter J. Wallison

Peter J. Wallison is a lawyer and the Arthur F. Burns Fellow in Financial Policy Studies at the American Enterprise Institute. He specializes in financial markets deregulation. He was White House Counsel during the Tower Commission's inquiry into the Iran Contra Affair...

, claim that the roots of the crisis can be traced directly to risky lending by Fannie Mae and Freddie Mac, which are government sponsored entities. Although Wallison's claims have received widespread attention in the media and by policy makers, the majority report of the Financial Crisis Inquiry Commission, several studies by Federal Reserve Economists, and the work of independent scholars who have carefully and scrupulously analyzed the data suggest that Wallison's claims are not supported by the data. In fact, the GSEs loans performed far better than loans securitized by private investment banks, and even than loans originated by institutions that held loans in their portfolios. On the whole, the GSEs appear to have had a conservative influence on mortgage underwriting.

Wallison has been widely criticized for attempting to politicize the investigation of the Financial Crisis Inquiry Commission, and his critics include fellow Republican Commissioners.

On September 30, 1999, The New York Times reported that the Clinton Administration pushed for more lending to low and moderate income borrowers, while the mortgage industry sought guarantees for sub-prime loans:

In the early and mid-2000s, the Bush administration called numerous times for investigation into the safety and soundness of the GSEs and their swelling portfolio of subprime mortgages. On September 10, 2003 the House Financial Services Committee held a hearing at the urging of the administration to assess safety and soundness issues and to review a recent report by the Office of Federal Housing Enterprise Oversight

Office of Federal Housing Enterprise Oversight

The Office of Federal Housing Enterprise Oversight was an agency within the Department of Housing and Urban Development. It was charged with ensuring the capital adequacy and financial safety and soundness of two government sponsored enterprises—the Federal National Mortgage Association and the...

(OFHEO) that had uncovered accounting discrepancies within the two entities. The hearings never resulted in new legislation or formal investigation of Fannie Mae and Freddie Mac, as many of the committee members refused to accept the report and instead rebuked OFHEO for their attempt at regulation. Some believe this was an early warning to the systemic risk that the growing market in subprime mortgages posed to the U.S. financial system that went unheeded.

A 2000 United States Department of the Treasury

United States Department of the Treasury

The Department of the Treasury is an executive department and the treasury of the United States federal government. It was established by an Act of Congress in 1789 to manage government revenue...

study of lending trends for 305 cities from 1993 to 1998 showed that $467 billion of mortgage lending was made by Community Reinvestment Act

Community Reinvestment Act

The Community Reinvestment Act is a United States federal law designed to encourage commercial banks and savings associations to help meet the needs of borrowers in all segments of their communities, including low- and moderate-income neighborhoods...

(CRA)-covered lenders into low and mid level income (LMI) borrowers and neighborhoods, representing 10% of all US mortgage lending during the period. The majority of these were prime loans. Sub-prime loans made by CRA-covered institutions constituted a 3% market share of LMI loans in 1998. Nevertheless, only 25% of all sub-prime lending occurred at CRA-covered institutions, and a full 50% of sub-prime loans originated at institutions exempt from CRA.

An analysis by the Federal Reserve Bank of Dallas in 2009 concluded unequivocally that the CRA was not responsible for the mortgage loan crisis, pointing out that CRA rules have been in place since 1995 whereas the poor lending emerged only a decade later. Furthermore, most sub-prime loans were not made to the LMI borrowers targeted by the CRA, especially in the years 2005-2006 leading up to the crisis. Nor did it find any evidence that lending under the CRA rules increased delinquency rates or that the CRA indirectly influenced independent mortgage lenders to ramp up sub-prime lending.

Others have pointed out that there were not enough of these loans made to cause a crisis of this magnitude. In an article in Portfolio Magazine, Michael Lewis

Michael Lewis (author)

Michael Lewis is an American non-fiction author and financial journalist. His bestselling books include The Big Short: Inside the Doomsday Machine, Liar's Poker, The New New Thing, Moneyball: The Art of Winning an Unfair Game, The Blind Side: Evolution of a Game, Panic and Home Game: An...

spoke with one trader who noted that "There weren’t enough Americans with [bad] credit taking out [bad loans] to satisfy investors’ appetite for the end product." Essentially, investment banks and hedge funds used financial innovation

Financial innovation

There are several interpretations of the phrase financial innovation. In general, it refers to the creating and marketing of new types of securities.- Why does financial innovation occur? :...

to enable large wagers to be made, far beyond the actual value of the underlying mortgage loans, using derivatives

Derivative (finance)

A derivative instrument is a contract between two parties that specifies conditions—in particular, dates and the resulting values of the underlying variables—under which payments, or payoffs, are to be made between the parties.Under U.S...

called credit default swaps, CDO

Collateralized debt obligation

Collateralized debt obligations are a type of structured asset-backed security with multiple "tranches" that are issued by special purpose entities and collateralized by debt obligations including bonds and loans. Each tranche offers a varying degree of risk and return so as to meet investor demand...

and synthetic CDO

Synthetic CDO

A Synthetic CDO is a complex financial security used to speculate or manage the risk that an obligation will not be paid...

. As long as derivative buyers could be matched with sellers, the theoretical amount that could be wagered was infinite. "They were creating [synthetic loans] out of whole cloth. One hundred times over! That’s why the losses are so much greater than the loans."

Economist Paul Krugman

Paul Krugman

Paul Robin Krugman is an American economist, professor of Economics and International Affairs at the Woodrow Wilson School of Public and International Affairs at Princeton University, Centenary Professor at the London School of Economics, and an op-ed columnist for The New York Times...

argued in January 2010 that the simultaneous growth of the residential and commercial real estate pricing bubbles undermines the case made by those who argue that Fannie Mae, Freddie Mac, CRA or predatory lending were primary causes of the crisis. In other words, bubbles in both markets developed even though only the residential market was affected by these potential causes.

As of March 2011 the FDIC has had to pay out $9 billion to cover losses on bad loans at 165 failed financial institutions.

Growth of the housing bubble

Between 1997 and 2006, the price of the typical American house increased by 124%. During the two decades ending in 2001, the national median home price ranged from 2.9 to 3.1 times median household income. This ratio rose to 4.0 in 2004, and 4.6 in 2006. This housing bubble resulted in quite a few homeowners refinancing their homes at lower interest rates, or financing consumer spending by taking out second mortgage

Second mortgage

A second mortgage typically refers to a secured loan that is subordinate to another loan against the same property.In real estate, a property can have multiple loans or liens against it. The loan which is registered with county or city registry first is called the first mortgage or first position...

s secured by the price appreciation.

In a Peabody Award

Peabody Award

The George Foster Peabody Awards recognize distinguished and meritorious public service by radio and television stations, networks, producing organizations and individuals. In 1939, the National Association of Broadcasters formed a committee to recognize outstanding achievement in radio broadcasting...

winning program, NPR correspondents argued that a "Giant Pool of Money" (represented by $70 trillion in worldwide fixed income investments) sought higher yields than those offered by U.S. Treasury bonds early in the decade. This pool of money had roughly doubled in size from 2000 to 2007, yet the supply of relatively safe, income generating investments had not grown as fast. Investment banks on Wall Street answered this demand with the MBS and CDO, which were assigned safe ratings

Credit rating

A credit rating evaluates the credit worthiness of an issuer of specific types of debt, specifically, debt issued by a business enterprise such as a corporation or a government. It is an evaluation made by a credit rating agency of the debt issuers likelihood of default. Credit ratings are...

by the credit rating agencies

Credit rating agencies and the subprime crisis

Credit rating agencies played a very important role at various stages in the subprime crisis. They have been highly criticized for understating the risk involved with new, complex securities that fueled the United States housing bubble, such as mortgage-backed securities and collateralized debt...

.

In effect, Wall Street connected this pool of money to the mortgage market in the U.S., with enormous fees accruing to those throughout the mortgage supply chain

Supply chain

A supply chain is a system of organizations, people, technology, activities, information and resources involved in moving a product or service from supplier to customer. Supply chain activities transform natural resources, raw materials and components into a finished product that is delivered to...

, from the mortgage broker selling the loans, to small banks that funded the brokers, to the giant investment banks behind them. By approximately 2003, the supply of mortgages originated at traditional lending standards had been exhausted. However, continued strong demand for MBS and CDO began to drive down lending standards, as long as mortgages could still be sold along the supply chain. Eventually, this speculative bubble proved unsustainable.

The CDO in particular enabled financial institutions to obtain investor funds to finance subprime and other lending, extending or increasing the housing bubble and generating large fees. A CDO essentially places cash payments from multiple mortgages or other debt obligations into a single pool, from which the cash is allocated to specific securities in a priority sequence. Those securities obtaining cash first received investment-grade ratings from rating agencies. Lower priority securities received cash thereafter, with lower credit ratings but theoretically a higher rate of return on the amount invested.

By September 2008, average U.S. housing prices had declined by over 20% from their mid-2006 peak. As prices declined, borrowers with adjustable-rate mortgages could not refinance to avoid the higher payments associated with rising interest rates and began to default. During 2007, lenders began foreclosure proceedings on nearly 1.3 million properties, a 79% increase over 2006. This increased to 2.3 million in 2008, an 81% increase vs. 2007. By August 2008, 9.2% of all U.S. mortgages outstanding were either delinquent or in foreclosure. By September 2009, this had risen to 14.4%.

Easy credit conditions

Lower interest rates encourage borrowing. From 2000 to 2003, the Federal Reserve lowered the federal funds rate

Federal funds rate

In the United States, the federal funds rate is the interest rate at which depository institutions actively trade balances held at the Federal Reserve, called federal funds, with each other, usually overnight, on an uncollateralized basis. Institutions with surplus balances in their accounts lend...

target from 6.5% to 1.0%. This was done to soften the effects of the collapse of the dot-com bubble

Dot-com bubble

The dot-com bubble was a speculative bubble covering roughly 1995–2000 during which stock markets in industrialized nations saw their equity value rise rapidly from growth in the more...

and of the September 2001 terrorist attacks, and to combat the perceived risk of deflation.
Additional downward pressure on interest rates was created by the USA's high and rising current account

Current account

In economics, the current account is one of the two primary components of the balance of payments, the other being the capital account. The current account is the sum of the balance of trade , net factor income and net transfer payments .The current account balance is one of two major...

deficit, which peaked along with the housing bubble in 2006. Federal Reserve Chairman Ben Bernanke

Ben Bernanke

Ben Shalom Bernanke is an American economist, and the current Chairman of the Federal Reserve, the central bank of the United States. During his tenure as Chairman, Bernanke has overseen the response of the Federal Reserve to late-2000s financial crisis....

explained how trade deficits required the U.S. to borrow money from abroad, which bid up bond prices and lowered interest rates.

Bernanke explained that between 1996 and 2004, the USA current account deficit increased by $650 billion, from 1.5% to 5.8% of GDP

Gross domestic product

Gross domestic product refers to the market value of all final goods and services produced within a country in a given period. GDP per capita is often considered an indicator of a country's standard of living....

. Financing these deficits required the USA to borrow large sums from abroad, much of it from countries running trade surpluses, mainly the emerging economies in Asia and oil-exporting nations. The balance of payments

Balance of payments

Balance of payments accounts are an accounting record of all monetary transactions between a country and the rest of the world.These transactions include payments for the country's exports and imports of goods, services, financial capital, and financial transfers...

identity

Identity (mathematics)

In mathematics, the term identity has several different important meanings:*An identity is a relation which is tautologically true. This means that whatever the number or value may be, the answer stays the same. For example, algebraically, this occurs if an equation is satisfied for all values of...

requires that a country (such as the USA) running a current account

Current account

deficit also have a capital account

Capital account

The current and capital accounts make up a country's balance of payment . Together these three accounts tell a story about the state of an economy, its economic outlook and its strategies for achieving its desired goals...

(investment) surplus of the same amount. Hence large and growing amounts of foreign funds (capital) flowed into the USA to finance its imports.

This created demand for various types of financial assets, raising the prices of those assets while lowering interest rates. Foreign investors had these funds to lend, either because they had very high personal savings rates (as high as 40% in China), or because of high oil prices. Bernanke referred to this as a "saving glut."

A "flood" of funds (capital

Financial capital

Financial capital can refer to money used by entrepreneurs and businesses to buy what they need to make their products or provide their services or to that sector of the economy based on its operation, i.e. retail, corporate, investment banking, etc....

or liquidity) reached the USA financial markets. Foreign governments supplied funds by purchasing USA Treasury bonds and thus avoided much of the direct impact of the crisis. USA households, on the other hand, used funds borrowed from foreigners to finance consumption or to bid up the prices of housing and financial assets. Financial institutions invested foreign funds in mortgage-backed securities.

The Fed then raised the Fed funds rate significantly between July 2004 and July 2006. This contributed to an increase in 1-year and 5-year adjustable-rate mortgage (ARM) rates, making ARM interest rate resets more expensive for homeowners. This may have also contributed to the deflating of the housing bubble, as asset prices generally move inversely to interest rates and it became riskier to speculate in housing. USA housing and financial assets dramatically declined in value after the housing bubble burst.

Weak and fraudulent underwriting practice

Testimony given to the Financial Crisis Inquiry Commission

Financial Crisis Inquiry Commission

by Richard M. Bowen, III on events during his tenure as Citi's

Citigroup

Citigroup Inc. or Citi is an American multinational financial services corporation headquartered in Manhattan, New York City, New York, United States. Citigroup was formed from one of the world's largest mergers in history by combining the banking giant Citicorp and financial conglomerate...

Business Chief Underwriter for Correspondent Lending in the Consumer Lending Group (where he was responsible for over 220 professional underwriters) suggests that by the final years of the US housing bubble (2006–2007), the collapse of mortgage underwriting standards was endemic. His testimony stated that by 2006, 60% of mortgages purchased by Citi

Citigroup

from some 1,600 mortgage companies were "defective" (were not underwritten to policy, or did not contain all policy-required documents). This, despite the fact that each of these 1,600 originators were contractually responsible (certified via representations and warrantees) that their mortgage originations met Citi's

Citigroup

standards. Moreover, during 2007, "defective mortgages (from mortgage originators contractually bound to perform underwriting to Citi's

Citigroup

standards) increased... to over 80% of production".

In separate testimony to Financial Crisis Inquiry Commission, officers of Clayton Holdings—the largest residential loan due diligence and securitization surveillance company in the United States and Europe—testified that Clayton's review of over 900,000 mortgages issued from January 2006 to June 2007 revealed that scarcely 54% of the loans met their originators’ underwriting standards. The analysis (conducted on behalf of 23 investment and commercial banks, including 7 "Too Big To Fail

Too Big to Fail

Too Big to Fail is a television drama film in the United States broadcast on HBO on May 23, 2011. It is based on the non-fiction book Too Big to Fail by Andrew Ross Sorkin. The TV film was directed by Curtis Hanson...

" banks) additionally showed that 28% of the sampled loans did not meet the minimal standards of any issuer. Clayton's analysis further showed that 39% of these loans (i.e. those not meeting any issuer's minimal underwriting standards) were subsequently securitized and sold to investors.

There is strong evidence that the GSEs—due to their large size and market power—were far more effective at policing underwriting by originators and forcing underwriters to repurchase defective loans. By contrast, private securitizers have been far less aggressive and less effective in recovering losses from originators on behalf of investors.

Predatory lending

Predatory lending refers to the practice of unscrupulous lenders, enticing borrowers to enter into "unsafe" or "unsound" secured loans for inappropriate purposes. A classic bait-and-switch method was used by Countrywide Financial

Countrywide Financial

Bank of America Home Loans is the mortgage unit of Bank of America. Bank of America Home Loans is composed of:*Mortgage Banking, which originates purchases, securitizes, and services mortgages. In 2008, Bank of America purchased the failing Countrywide Financial for $4.1 billion...

, advertising low interest rates for home refinancing. Such loans were written into extensively detailed contracts, and swapped for more expensive loan products on the day of closing. Whereas the advertisement might state that 1% or 1.5% interest would be charged, the consumer would be put into an adjustable rate mortgage (ARM) in which the interest charged would be greater than the amount of interest paid. This created negative amortization

Negative amortization

In finance, negative amortization, also known as NegAm, deferred interest or graduated payment mortgage, occurs whenever the loan payment for any period is less than the interest charged over that period so that the outstanding balance of the loan increases...

, which the credit consumer might not notice until long after the loan transaction had been consummated.

Countrywide, sued by California Attorney General Jerry Brown for "unfair business practices" and "false advertising" was making high cost mortgages "to homeowners with weak credit, adjustable rate mortgages (ARMs) that allowed homeowners to make interest-only payments". When housing prices decreased, homeowners in ARMs then had little incentive to pay their monthly payments, since their home equity had disappeared. This caused Countrywide's financial condition to deteriorate, ultimately resulting in a decision by the Office of Thrift Supervision to seize the lender.

Former employees from Ameriquest

Ameriquest

ACC Capital Holdings was a national mortgage lender based in Orange, California. The company is the largest privately held retail mortgage lender in the United States and the largest subprime lender by volume...

, which was United States' leading wholesale lender, described a system in which they were pushed to falsify mortgage documents and then sell the mortgages to Wall Street banks eager to make fast profits. There is growing evidence that such mortgage fraud

Mortgage fraud

Mortgage fraud is crime in which the intent is to materially misrepresent or omit information on a mortgage loan application to obtain a loan or to obtain a larger loan than would have been obtained had the lender or borrower known the truth....

s may be a cause of the crisis.

Deregulation

Critics such as economist Paul Krugman

Paul Krugman

and U.S. Treasury Secretary Timothy Geithner have argued that the regulatory framework did not keep pace with financial innovation

Financial innovation

There are several interpretations of the phrase financial innovation. In general, it refers to the creating and marketing of new types of securities.- Why does financial innovation occur? :...

, such as the increasing importance of the shadow banking system

Shadow banking system

, derivatives and off-balance sheet financing. In other cases, laws were changed or enforcement weakened in parts of the financial system. Key examples include:

Jimmy Carter
Jimmy Carter
James Earl "Jimmy" Carter, Jr. is an American politician who served as the 39th President of the United States and was the recipient of the 2002 Nobel Peace Prize, the only U.S. President to have received the Prize after leaving office...

's Depository Institutions Deregulation and Monetary Control Act
Depository Institutions Deregulation and Monetary Control Act
The Depository Institutions Deregulation and Monetary Control Act, a United States federal financial statute law passed in 1980, gave the Federal Reserve greater control over non-member banks.* It forced all banks to abide by the Fed's rules....

of 1980 (DIDMCA) phased out a number of restrictions on banks' financial practices, broadened their lending powers, and raised the deposit insurance
Deposit insurance
Explicit deposit insurance is a measure implemented in many countries to protect bank depositors, in full or in part, from losses caused by a bank's inability to pay its debts when due...

limit from $40,000 to $100,000 (raising the problem of moral hazard
Moral hazard
In economic theory, moral hazard refers to a situation in which a party makes a decision about how much risk to take, while another party bears the costs if things go badly, and the party insulated from risk behaves differently from how it would if it were fully exposed to the risk.Moral hazard...

). Banks rushed into real estate
Real estate
In general use, esp. North American, 'real estate' is taken to mean "Property consisting of land and the buildings on it, along with its natural resources such as crops, minerals, or water; immovable property of this nature; an interest vested in this; an item of real property; buildings or...

lending, speculative lending, and other ventures just as the economy soured.
In October 1982, U.S. President Ronald Reagan signed into law the Garn–St. Germain Depository Institutions Act, which provided for adjustable-rate mortgage loans, began the process of banking deregulation, and contributed to the savings and loan crisis
Savings and Loan crisis
The savings and loan crisis of the 1980s and 1990s was the failure of about 747 out of the 3,234 savings and loan associations in the United States...

of the late 1980s/early 1990s.
In November 1999, U.S. President Bill Clinton signed into law the Gramm–Leach–Bliley Act, which repealed part of the Glass–Steagall Act of 1933. This repeal has been criticized for reducing the separation between commercial banks (which traditionally had fiscally conservative policies) and investment banks (which had a more risk-taking culture).
In 2004, the U.S. Securities and Exchange Commission relaxed the net capital rule
Net capital rule
The uniform net capital rule is a rule created by the U.S. Securities and Exchange Commission in 1975 to regulate directly the ability of broker-dealers to meet their financial obligations to customers and other creditors...

, which enabled investment banks to substantially increase the level of debt they were taking on, fueling the growth in mortgage-backed securities supporting subprime mortgages. The SEC has conceded that self-regulation of investment banks contributed to the crisis.
Financial institutions in the shadow banking system
Shadow banking system
The shadow banking system is the infrastructure and practices which support financial transactions that occur beyond the reach of existing state sanctioned monitoring and regulation. It includes entities such as hedge funds, money market funds and Structured investment vehicles...

are not subject to the same regulation as depository banks, allowing them to assume additional debt obligations relative to their financial cushion or capital base. This was the case despite the Long-Term Capital Management
Long-Term Capital Management
Long-Term Capital Management L.P. was a speculative hedge fund based in Greenwich, Connecticut that utilized absolute-return trading strategies combined with high leverage...

debacle in 1998, where a highly-leveraged shadow institution failed with systemic implications.
Regulators and accounting standard-setters allowed depository banks such as Citigroup
Citigroup
Citigroup Inc. or Citi is an American multinational financial services corporation headquartered in Manhattan, New York City, New York, United States. Citigroup was formed from one of the world's largest mergers in history by combining the banking giant Citicorp and financial conglomerate...

to move significant amounts of assets and liabilities off-balance sheet into complex legal entities called structured investment vehicles, masking the weakness of the capital base of the firm or degree of leverage or risk taken. One news agency estimated that the top four U.S. banks will have to return between $500 billion and $1 trillion to their balance sheets during 2009. This increased uncertainty during the crisis regarding the financial position of the major banks. Off-balance sheet entities were also used by Enron
Enron scandal
The Enron scandal, revealed in October 2001, eventually led to the bankruptcy of the Enron Corporation, an American energy company based in Houston, Texas, and the dissolution of Arthur Andersen, which was one of the five largest audit and accountancy partnerships in the world...

as part of the scandal that brought down that company in 2001.
As early as 1997, Federal Reserve Chairman Alan Greenspan
Alan Greenspan
Alan Greenspan is an American economist who served as Chairman of the Federal Reserve of the United States from 1987 to 2006. He currently works as a private advisor and provides consulting for firms through his company, Greenspan Associates LLC...

fought to keep the derivatives market unregulated. With the advice of the President's Working Group on Financial Markets
Working Group on Financial Markets
The Working Group on Financial Markets was created by Executive Order 12631, signed on March 18, 1988 by United States President Ronald Reagan.The Group was established explicitly in response to events in the financial markets surrounding October 19,...

, the U.S. Congress and President allowed the self-regulation of the over-the-counter
Over-the-counter (finance)
Within the derivatives markets, many products are traded through exchanges. An exchange has the benefit of facilitating liquidity and also mitigates all credit risk concerning the default of a member of the exchange. Products traded on the exchange must be well standardised to transparent trading....

derivatives market when they enacted the Commodity Futures Modernization Act of 2000
Commodity Futures Modernization Act of 2000
The Commodity Futures Modernization Act of 2000 is United States federal legislation that officially ensured the deregulation of financial products known as over-the-counter derivatives. It was signed into law on December 21, 2000 by President Bill Clinton...

. Derivatives such as credit default swaps (CDS) can be used to hedge or speculate against particular credit risks. The volume of CDS outstanding increased 100-fold from 1998 to 2008, with estimates of the debt covered by CDS contracts, as of November 2008, ranging from US$33 to $47 trillion. Total over-the-counter (OTC) derivative notional value rose to $683 trillion by June 2008. Warren Buffett
Warren Buffett
Warren Edward Buffett is an American business magnate, investor, and philanthropist. He is widely regarded as one of the most successful investors in the world. Often introduced as "legendary investor, Warren Buffett", he is the primary shareholder, chairman and CEO of Berkshire Hathaway. He is...

famously referred to derivatives as "financial weapons of mass destruction" in early 2003.

Increased debt burden or over-leveraging

Prior to the crisis, financial Institutions became highly leveraged, increasing their appetite for risky investments and reducing their resilience in case of losses. Much of this leverage was achieved using complex financial instruments such as off-balance sheet securitization and derivatives, which made it difficult for creditors and regulators to monitor and try to reduce financial institution risk levels. These instruments also made it virtually impossible to reorganize financial institutions in bankruptcy, and contributed to the need for government bailouts.

U.S. households and financial institutions became increasingly indebted or overleveraged during the years preceding the crisis. This increased their vulnerability to the collapse of the housing bubble and worsened the ensuing economic downturn. Key statistics include:

Free cash used by consumers from home equity extraction doubled from $627 billion in 2001 to $1,428 billion in 2005 as the housing bubble built, a total of nearly $5 trillion dollars over the period, contributing to economic growth worldwide. U.S. home mortgage debt relative to GDP increased from an average of 46% during the 1990s to 73% during 2008, reaching $10.5 trillion.

USA household debt as a percentage of annual disposable personal income was 127% at the end of 2007, versus 77% in 1990.

In 1981, U.S. private debt was 123% of GDP; by the third quarter of 2008, it was 290%.

From 2004-07, the top five U.S. investment banks each significantly increased their financial leverage (see diagram), which increased their vulnerability to a financial shock. These five institutions reported over $4.1 trillion in debt for fiscal year 2007, about 30% of USA nominal GDP for 2007. Lehman Brothers

Lehman Brothers

Lehman Brothers Holdings Inc. was a global financial services firm. Before declaring bankruptcy in 2008, Lehman was the fourth largest investment bank in the USA , doing business in investment banking, equity and fixed-income sales and trading Lehman Brothers Holdings Inc. (former NYSE ticker...

was liquidated, Bear Stearns

Bear Stearns

The Bear Stearns Companies, Inc. based in New York City, was a global investment bank and securities trading and brokerage, until its sale to JPMorgan Chase in 2008 during the global financial crisis and recession...

and Merrill Lynch

Merrill Lynch

Merrill Lynch is the wealth management division of Bank of America. With over 15,000 financial advisors and $2.2 trillion in client assets it is the world's largest brokerage. Formerly known as Merrill Lynch & Co., Inc., prior to 2009 the firm was publicly owned and traded on the New York...

were sold at fire-sale prices, and Goldman Sachs

Goldman Sachs

The Goldman Sachs Group, Inc. is an American multinational bulge bracket investment banking and securities firm that engages in global investment banking, securities, investment management, and other financial services primarily with institutional clients...

and Morgan Stanley

Morgan Stanley

Morgan Stanley is a global financial services firm headquartered in New York City serving a diversified group of corporations, governments, financial institutions, and individuals. Morgan Stanley also operates in 36 countries around the world, with over 600 offices and a workforce of over 60,000....

became commercial banks, subjecting themselves to more stringent regulation. With the exception of Lehman, these companies required or received government support.

Fannie Mae and Freddie Mac, two U.S. Government sponsored enterprises, owned or guaranteed nearly $5 trillion in mortgage obligations at the time they were placed into conservatorship

Conservatorship

Conservatorship is a legal concept in the United States of America, where an entity or organization is subjected to the legal control of an external entity or organization, known as a conservator. Conservatorship is established either by court order or via a statutory or regulatory authority...

by the U.S. government in September 2008.

These seven entities were highly leveraged and had $9 trillion in debt or guarantee obligations; yet they were not subject to the same regulation as depository banks.

Financial innovation and complexity

The term financial innovation

Financial innovation

There are several interpretations of the phrase financial innovation. In general, it refers to the creating and marketing of new types of securities.- Why does financial innovation occur? :...

refers to the ongoing development of financial products designed to achieve particular client objectives, such as offsetting a particular risk exposure (such as the default of a borrower) or to assist with obtaining financing. Examples pertinent to this crisis included: the adjustable-rate mortgage; the bundling of subprime mortgages into mortgage-backed securities (MBS) or collateralized debt obligations (CDO) for sale to investors, a type of securitization

Securitization

Securitization is the financial practice of pooling various types of contractual debt such as residential mortgages, commercial mortgages, auto loans or credit card debt obligations and selling said consolidated debt as bonds, pass-through securities, or Collateralized mortgage obligation , to...

; and a form of credit insurance called credit default swaps (CDS). The usage of these products expanded dramatically in the years leading up to the crisis. These products vary in complexity and the ease with which they can be valued on the books of financial institutions.

CDO issuance grew from an estimated $20 billion in Q1 2004 to its peak of over $180 billion by Q1 2007, then declined back under $20 billion by Q1 2008. Further, the credit quality of CDO's declined from 2000–2007, as the level of subprime and other non-prime mortgage debt increased from 5% to 36% of CDO assets. As described in the section on subprime lending, the CDS and portfolio of CDS called synthetic CDO

Synthetic CDO

A Synthetic CDO is a complex financial security used to speculate or manage the risk that an obligation will not be paid...

enabled a theoretically infinite amount to be wagered on the finite value of housing loans outstanding, provided that buyers and sellers of the derivatives could be found. For example, buying a CDS to insure a CDO ended up giving the seller the same risk as if they owned the CDO, when those CDO's became worthless.
This boom in innovative financial products went hand in hand with more complexity. It multiplied the number of actors connected to a single mortgage (including mortgage brokers, specialized originators, the securitizers and their due diligence firms, managing agents and trading desks, and finally investors, insurances and providers of repo funding). With increasing distance from the underlying asset these actors relied more and more on indirect information (including FICO scores on creditworthiness, appraisals and due diligence checks by third party organizations, and most importantly the computer models of rating agencies and risk management desks). Instead of spreading risk this provided the ground for fraudulent acts, misjudgments and finally market collapse.

Martin Wolf

Martin Wolf

Martin Wolf, CBE is a British journalist, widely considered to be one of the world's most influential writers on economics. He is associate editor and chief economics commentator at the Financial Times.-Early life:...

further wrote in June 2009 that certain financial innovations enabled firms to circumvent regulations, such as off-balance sheet financing that affects the leverage or capital cushion reported by major banks, stating: "...an enormous part of what banks did in the early part of this decade – the off-balance-sheet vehicles, the derivatives and the 'shadow banking system' itself – was to find a way round regulation."

Incorrect pricing of risk

The pricing of risk refers to the incremental compensation

Risk premium

A risk premium is the minimum amount of money by which the expected return on a risky asset must exceed the known return on a risk-free asset, in order to induce an individual to hold the risky asset rather than the risk-free asset...

required by investors for taking on additional risk, which may be measured by interest rates or fees. Several scholars have argued that a lack of transparency about banks' risk exposures prevented markets from correctly pricing risk before the crisis, enabled the mortgage market to grow larger than it otherwise would have, and made the financial crisis far more disruptive than it would have been if risk levels had been disclosed in a straightforward, readily understandable format.

For a variety of reasons, market participants did not accurately measure the risk inherent with financial innovation such as MBS and CDOs or understand its impact on the overall stability of the financial system. For example, the pricing model for CDOs clearly did not reflect the level of risk they introduced into the system. Banks estimated that $450bn of CDO were sold between "late 2005 to the middle of 2007"; among the $102bn of those that had been liquidated, JPMorgan estimated that the average recovery rate for "high quality" CDOs was approximately 32 cents on the dollar, while the recovery rate for mezzanine

Mezzanine capital

Mezzanine capital, in finance, refers to a subordinated debt or preferred equity instrument that represents a claim on a company's assets which is senior only to that of the common shares...

CDO was approximately five cents for every dollar.

Another example relates to AIG

AIG

AIG is American International Group, a major American insurance corporation.AIG may also refer to:* And-inverter graph, a concept in computer theory* Answers in Genesis, a creationist organization in the U.S.* Arta Industrial Group in Iran...

, which insured obligations of various financial institutions through the usage of credit default swaps. The basic CDS transaction involved AIG receiving a premium in exchange for a promise to pay money to party A in the event party B defaulted. However, AIG did not have the financial strength to support its many CDS commitments as the crisis progressed and was taken over by the government in September 2008. U.S. taxpayers provided over $180 billion in government support to AIG during 2008 and early 2009, through which the money flowed to various counterparties to CDS transactions, including many large global financial institutions.

The limitations of a widely-used financial model also were not properly understood. This formula assumed that the price of CDS was correlated with and could predict the correct price of mortgage backed securities. Because it was highly tractable, it rapidly came to be used by a huge percentage of CDO and CDS investors, issuers, and rating agencies. According to one wired.com article:

As financial assets became more and more complex, and harder and harder to value, investors were reassured by the fact that both the international bond rating agencies and bank regulators, who came to rely on them, accepted as valid some complex mathematical models which theoretically showed the risks were much smaller than they actually proved to be. George Soros

George Soros

George Soros is a Hungarian-American business magnate, investor, philosopher, and philanthropist. He is the chairman of Soros Fund Management. Soros supports progressive-liberal causes...

commented that "The super-boom got out of hand when the new products became so complicated that the authorities could no longer calculate the risks and started relying on the risk management methods of the banks themselves. Similarly, the rating agencies relied on the information provided by the originators of synthetic products. It was a shocking abdication of responsibility."

Moreover, a conflict of interest between professional investment managers

Investment management

Investment management is the professional management of various securities and assets in order to meet specified investment goals for the benefit of the investors...

and their institutional clients

Institutional investor

Institutional investors are organizations which pool large sums of money and invest those sums in securities, real property and other investment assets...

, combined with a global glut in investment capital, led to bad investments by asset managers in over-priced credit assets. Professional investment managers generally are compensated based on the volume of client assets under management

Assets under management

Assets under management is a financial term used denote the market value of funds being managed by a financial instutition on behalf of its clients, investors, depositors, etc. This metric is a sign of size and success against competition...

. There is, therefore, an incentive for asset managers to expand their assets under management in order to maximize their compensation. As the glut in global investment capital caused the yields on credit assets to decline, asset managers were faced with the choice of either investing in assets where returns did not reflect true credit risk or returning funds to clients. Many asset managers chose to continue to invest client funds in over-priced (under-yielding) investments, to the detriment of their clients, in order to maintain their assets under management. This choice was supported by a "plausible deniability" of the risks associated with subprime-based credit assets because the loss experience with early "vintages" of subprime loans was so low.

Despite the dominance of the above formula, there are documented attempts of the financial industry, occurring before the crisis, to address the formula limitations, specifically the lack of dependence dynamics and the poor representation of extreme events. The volume "Credit Correlation: Life After Copulas", published in 2007 by World Scientific, summarizes a 2006 conference held by Merrill Lynch in London where several practitioners attempted to propose models rectifying some of the copula limitations. See also the article by Donnelly and Embrechts
and the book by Brigo, Pallavicini and Torresetti, that reports relevant warnings and research on CDOs appeared in 2006.

Boom and collapse of the shadow banking system

There is strong evidence that the riskiest, worst performing mortgages were funded through the "shadow banking system" and that competition from the shadow banking system may have pressured more traditional institutions to lower their own underwriting standards and originate riskier loans.

In a June 2008 speech, President and CEO of the New York Federal Reserve Bank Timothy Geithnerwho in 2009 became Secretary of the United States Treasuryplaced 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

Shadow banking system

. These entities became critical to the credit markets underpinning the financial system, but were not subject to the same regulatory controls. Further, these entities were vulnerable because of maturity mismatch

Asset liability mismatch

In finance, an asset–liability mismatch occurs when the financial terms of an institution's assets and liabilities do not correspond. Several types of mismatches are possible....

, meaning that 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:

Paul Krugman

Paul Krugman

, laureate of the Nobel Prize in Economics

Nobel Memorial Prize in Economic Sciences

The Nobel Memorial Prize in Economic Sciences, commonly referred to as the Nobel Prize in Economics, but officially the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel , is an award for outstanding contributions to the field of economics, generally regarded as one of the...

, described the run on the shadow banking system as the "core of what happened" to cause the crisis. He referred to this lack of controls as "malign neglect" and argued that regulation should have been imposed on all banking-like activity.

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

Brookings Institution

The Brookings Institution is a nonprofit public policy organization based in Washington, D.C., in the United States. One of Washington's oldest think tanks, Brookings conducts research and education in the social sciences, primarily in economics, metropolitan policy, governance, foreign policy, and...

, 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 artifact of excessively loose credit conditions."

Economist Mark Zandi

Mark Zandi

Mark Zandi is an Iranian American economist and co-founder of Moody's Economy.com, a widely-cited source of economic analysis.. Moody's Economy.com is part of Moody's Analytics. Prior to founding Economy.com, Zandi was a regional economist at Chase Econometrics.He was born in Atlanta, Georgia of...

testified to the Financial Crisis Inquiry Commission

Financial Crisis Inquiry Commission

in January 2010:
"The securitization markets also remain impaired, as investors anticipate more loan losses. Investors are also uncertain about coming legal and accounting rule changes and regulatory reforms. Private bond issuance of residential and commercial mortgage-backed securities, asset-backed securities, and CDOs peaked in 2006 at close to $2 trillion...In 2009, private issuance was less than $150 billion, and almost all of it was asset-backed issuance supported by the Federal Reserve's TALF program to aid credit card, auto and small-business lenders. Issuance of residential and commercial mortgage-backed securities and CDOs remains dormant."

Commodities boom

Rapid increases in a number of commodity prices followed the collapse in the housing bubble. The price of oil nearly tripled from $50 to $147 from early 2007 to 2008, before plunging as the financial crisis began to take hold in late 2008. Experts debate the causes, with some attributing it to speculative flow of money from housing and other investments into commodities, some to monetary policy, and some to the increasing feeling of raw materials scarcity in a fast growing world, leading to long positions taken on those markets, such as Chinese increasing presence in Africa. An increase in oil prices tends to divert a larger share of consumer spending into gasoline, which creates downward pressure on economic growth in oil importing countries, as wealth flows to oil-producing states. A pattern of spiking instability in the price of oil over the decade leading up to the price high of 2008 has been recently identified. The destabilizing effects of this price variance has been proposed as a contributory factor in the financial crisis.

In testimony before the Senate Committee on Commerce, Science, and Transportation on June 3, 2008, former director of the CFTC Division of Trading & Markets (responsible for enforcement) Michael Greenberger specifically named the Atlanta-based IntercontinentalExchange

IntercontinentalExchange

IntercontinentalExchange, Inc., known as ICE, is an American financial company that operates Internet-based marketplaces which trade futures and over-the-counter energy and commodity contracts as well as derivative financial products...

, founded by Goldman Sachs

Goldman Sachs

, Morgan Stanley

Morgan Stanley

and BP

BP p.l.c. is a global oil and gas company headquartered in London, United Kingdom. It is the third-largest energy company and fourth-largest company in the world measured by revenues and one of the six oil and gas "supermajors"...

as playing a key role in speculative run-up of oil futures prices traded off the regulated futures exchanges in London and New York. However, the IntercontinentalExchange (ICE) had been regulated by both European and US authorities since its purchase of the International Petroleum Exchange in 2001. Mr Greenberger was later corrected on this matter.

Copper prices increased at the same time as the oil prices. Copper traded at about $2,500 per tonne from 1990 until 1999, when it fell to about $1,600. The price slump lasted until 2004 which saw a price surge that had copper reaching $7,040 per tonne in 2008.

Nickel

Nickel

Nickel is a chemical element with the chemical symbol Ni and atomic number 28. It is a silvery-white lustrous metal with a slight golden tinge. Nickel belongs to the transition metals and is hard and ductile...

prices boomed in the late 1990s, then the price of nickel imploded from around $51,000 /£36,700 per metric ton in May 2007 to about $11,550/£8,300 per metric ton in January 2009. Prices were only just starting to recover as of January 2010, but most of Australia's nickel mines had gone bankrupt by then. As the price for high grade nickel sulphate ore recovered in 2010, so did the Australian nickel mining industry.

Coincidentally with these price fluctuations, long-only commodity index funds became popular – by one estimate investment increased from $90 billion in 2006 to $200 billion at the end of 2007, while commodity prices increased 71% – which raised concern as to whether these index funds caused the commodity bubble. The empirical research has been mixed.

Systemic crisis

Another analysis, different from the mainstream

Mainstream

Mainstream is, generally, the common current thought of the majority. However, the mainstream is far from cohesive; rather the concept is often considered a cultural construct....

explanation, is that the financial crisis is merely a symptom of another, deeper crisis, which is a systemic crisis of capitalism itself.

Ravi Batra

Ravi Batra

Raveendra Nath "Ravi" Batra is an Indian-American economist, author, and professor at Southern Methodist University. Batra is the author of six international bestsellers, two of which appeared on The New York Times Best Seller list...

's theory is that growing inequality of financial capitalism

Financial capitalism

Financial capitalism is a form of capitalism where the intermediation of savings to investment becomes a dominant function in the economy, with implications for the political process and social evolution...

produces speculative bubbles that burst and result in depression and major political changes

The Downfall of Capitalism and Communism

The Downfall of Capitalism and Communism is a major work by Ravi Batra in the field of historical evolution, published in 1978. The book's full title is The Downfall of Capitalism and Communism: A New Study of History...

. He has also suggested that a "demand gap" related to differing wage and productivity growth explains deficit and debt dynamics important to stock market developments.

John Bellamy Foster

John Bellamy Foster

John Bellamy Foster is a professor of sociology at the University of Oregon and also editor of Monthly Review, an independent socialist magazine. His writings have focused on political economy, environmental sociology, and Marxist theory...

, a political economy analyst and editor of the Monthly Review

Monthly Review

Monthly Review is an independent Marxist journal published 11 times per year in New York City.-History:The publication was founded by Harvard University economics instructor Paul Sweezy, who became the first editor...

, believes that the decrease in GDP growth rates since the early 1970s is due to increasing market saturation

Market saturation

In economics, "market saturation" is a term used to describe a situation in which a product has become diffused within a market; the actual level of saturation can depend on consumer purchasing power; as well as competition, prices, and technology....

.

John C. Bogle wrote during 2005 that a series of unresolved challenges face capitalism that have contributed to past financial crises and have not been sufficiently addressed: Echoing the central thesis of James Burnham's

James Burnham

James Burnham was an American popular political theorist, best known for his influential work The Managerial Revolution, published in 1941. Burnham was a radical activist in the 1930s and an important factional leader of the American Trotskyist movement. In later years he left Marxism and produced...

1941 seminal book, The Managerial Revolution, Bolge cites particular issues, including:

that "Manager's capitalism" has replaced "owner's capitalism," meaning management runs the firm for its benefit rather than for the shareholders, a variation on the principal–agent problem;
the burgeoning executive compensation;
the management of earnings, mainly a focus on share price rather than the creation of genuine value; and
the failure of gatekeepers, including auditors, boards of directors, Wall Street analysts, and career politicians.

An analysis conducted by Mark Roeder, a former executive at the Swiss-based UBS Bank, suggested that large scale momentum, or The Big Mo

The Big Mo

The Big Mo is a term used to describe behavioural momentum that operates on a large scale. It was originally used as a sporting term during the 1960s in the United States, to describe the effect that momentum appeared to have on a team's performance. Successful teams were said to have "The Big Mo"...

"played a pivotal role" in the 2008-09 global financial crisis. Roeder suggested that "recent technological advances, such as computer-driven trading programs, together with the increasingly interconnected nature of markets, has magnified the momentum effect. This has made the financial sector inherently unstable."

Robert Reich

Robert Reich

Robert Bernard Reich is an American political economist, professor, author, and political commentator. He served in the administrations of Presidents Gerald Ford and Jimmy Carter and was Secretary of Labor under President Bill Clinton from 1993 to 1997....

has attributed the current economic downturn to the stagnation of wages in the United States, particularly those of the hourly workers who comprise 80% of the workforce. His claim is that this stagnation forced the population to borrow in order to meet the cost of living.

Role of economic forecasting

The financial crisis was not widely predicted by mainstream economists

Mainstream economics

Mainstream economics is a loose term used to refer to widely-accepted economics as taught in prominent universities and in contrast to heterodox economics...

, who instead spoke of the Great Moderation. A number of heterodox economists

Heterodox economics

"Heterodox economics" refers to approaches or to schools of economic thought that are considered outside of "mainstream economics". Mainstream economists sometimes assert that it has little or no influence on the vast majority of academic economists in the English speaking world. "Mainstream...

predicted the crisis, with varying arguments. Dirk Bezemer in his research credits (with supporting argument and estimates of timing) 12 economists with predicting the crisis: Dean Baker

Dean Baker

Dean Baker is an American macroeconomist and co-founder of the Center for Economic and Policy Research, with Mark Weisbrot. He previously was a senior economist at the Economic Policy Institute and an assistant professor of economics at Bucknell University. He has a Ph.D...

(US), Wynne Godley

Wynne Godley

Wynne Godley was an economist famous for his pessimism toward the British economy and his criticism of the British government....

(UK), Fred Harrison

Fred Harrison (author)

Fred Harrison is a British author, economic commentator and corporate policy advisor, notable for his stances on land reform and belief that an over reliance on land, property and mortgage weakens economic structures and makes companies vulnerable to economic collapse...

(UK), Michael Hudson

Michael Hudson (economist)

Michael Hudson is research professor of economics at University of Missouri, Kansas City and a research associate at the Levy Economics Institute of Bard College...

(US), Eric Janszen

Eric Janszen

Eric Janszen is an economic commentator and former venture capitalist. He founded the financial advisory company iTulip.Janszen wrote an analysis of economic bubbles in a 2008 Harper's Magazine article predicting a future alternative energy bubble bursting in the mid 2010s...

(US), Steve Keen

Steve Keen

Steve Keen is a Professor in economics and finance at the University of Western Sydney. He classes himself as a post-Keynesian, criticizing both modern neoclassical economics and Marxian economics as inconsistent, unscientific and empirically unsupported...

(Australia), Jakob Brøchner Madsen

Jakob Brochner Madsen

Jakob Brochner Madsen is an economist, professor and former financial analyst and deputy chief economist . He was one of few economist who predicted the IT bubble in 2001 and the housing bubble in 2006 and the global financial crisis.- Biography :He received his PhD in 1991...

& Jens Kjaer Sørensen (Denmark), Kurt Richebächer

Kurt Richebächer

Dr. Kurt Richebächer was an international banker and economist. He considered himself a follower of the Austrian School of Economics and was best known for his newsletter, "The Richebächer Letter," which at various times also circulated as "Currencies & Credit Markets."Dr...

(US), Nouriel Roubini

Nouriel Roubini

Nouriel Roubini is an American economist. He claims to have predicted both the collapse of the United States housing market and the worldwide recession which started in 2008. He teaches at New York University's Stern School of Business and is the chairman of Roubini Global Economics, an economic...

(US), Peter Schiff

Peter Schiff

Peter David Schiff is an American investment broker, author and financial commentator. Schiff is CEO and chief global strategist of Euro Pacific Capital Inc., a broker-dealer based in Westport, Connecticut and CEO of Euro Pacific Precious Metals, LLC, a gold and silver dealer based in New York...

(US), and Robert Shiller

Robert Shiller

Robert James "Bob" Shiller is an American economist, academic, and best-selling author. He currently serves as the Arthur M. Okun Professor of Economics at Yale University and is a Fellow at the Yale International Center for Finance, Yale School of Management...

(US). Examples of other experts who gave indications of a financial crisis have also been given. Not surprisingly, the Austrian economic school

Austrian School

The Austrian School of economics is a heterodox school of economic thought. It advocates methodological individualism in interpreting economic developments , the theory that money is non-neutral, the theory that the capital structure of economies consists of heterogeneous goods that have...

regarded the crisis as a vindication and classic example of a predictable credit-fueled bubble that could not forestall the disregarded but inevitable effect of an artificial, manufactured laxity in monetary supply, a perspective that even former Fed Chair Alan Greenspan in Congressional testimony confessed himself forced to return to.

A cover story in BusinessWeek

BusinessWeek

Bloomberg Businessweek, commonly and formerly known as BusinessWeek, is a weekly business magazine published by Bloomberg L.P. It is currently headquartered in New York City.- History :...

magazine claims that economists mostly failed to predict the worst international economic crisis since the Great Depression

Great Depression

of 1930s. The Wharton School of the University of Pennsylvania

Wharton School of the University of Pennsylvania

The Wharton School is the business school of the University of Pennsylvania, an Ivy League university in Philadelphia, Pennsylvania. Wharton was the world’s first collegiate business school and the first business school in the United States...

's online business journal examines why economists failed to predict a major global financial crisis. Popular articles published in the mass media have led the general public to believe that the majority of economists have failed in their obligation to predict the financial crisis. For example, an article in the New York Times informs that economist Nouriel Roubini

Nouriel Roubini

warned of such crisis as early as September 2006, and the article goes on to state that the profession of economics is bad at predicting recessions. According to The Guardian

The Guardian

The Guardian, formerly known as The Manchester Guardian , is a British national daily newspaper in the Berliner format...

, Roubini was ridiculed for predicting a collapse of the housing market and worldwide recession, while The New York Times labelled him "Dr. Doom".

Within mainstream financial economics

Financial economics

Financial Economics is the branch of economics concerned with "the allocation and deployment of economic resources, both spatially and across time, in an uncertain environment"....

, most believe that financial crises are simply unpredictable, following Eugene Fama

Eugene Fama

Eugene Francis "Gene" Fama is an American economist, known for his work on portfolio theory and asset pricing, both theoretical and empirical. He is currently Robert R...

's efficient-market hypothesis and the related random-walk hypothesis

Random walk hypothesis

The random walk hypothesis is a financial theory stating that stock market prices evolve according to a random walk and thus the prices of the stock market cannot be predicted. It is consistent with the efficient-market hypothesis....

, which state respectively that markets contain all information about possible future movements, and that the movement of financial prices are random and unpredictable.

Lebanese-American trader and financial risk engineer Nassim Nicholas Taleb, author of the 2007 book The Black Swan, spent years warning against the breakdown of the banking system in particular and the economy in general owing to their use of bad risk models and reliance on forecasting, and their reliance on bad models, and framed the problem as part of "robustness and fragility". He also took action against the establishment view by making a big financial bet on banking stocks and making a fortune from the crisis ("They didn't listen, so I took their money"). According to David Brooks from the New York Times, "Taleb not only has an explanation for what’s happening, he saw it coming."

US stock market

The US stock market peaked in October 2007, when the Dow Jones Industrial Average

Dow Jones Industrial Average

The Dow Jones Industrial Average , also called the Industrial Average, the Dow Jones, the Dow 30, or simply the Dow, is a stock market index, and one of several indices created by Wall Street Journal editor and Dow Jones & Company co-founder Charles Dow...

index exceeded 14,000 points. It then entered a pronounced decline, which accelerated markedly in October 2008. By March 2009, the Dow Jones average reached a trough of around 6,600. It has since recovered much of the decline, exceeding 12,000 for most of the first half of 2011. Likely, the aggressive Federal Reserve policy of quantitative easing spurred the recovery in the stock market.

Market strategist Phil Dow "said he believes distinctions exist between the current market malaise" and the Great Depression. The Dow's fall of over 50% in 17 months is similar to a 54.7% fall in the Great Depression, followed by a total drop of 89% over the next 16 months. "It's very troubling if you have a mirror image," said Dow. Floyd Norris

Floyd Norris

Floyd Norris born September 6, 1947 Los Angeles) is chief financial correspondent of The New York Times and The International Herald Tribune.He writes a regular column on the stock market for the Times, plus a blog.-Biography:...

, chief financial correspondent of The New York Times

The New York Times

The New York Times is an American daily newspaper founded and continuously published in New York City since 1851. The New York Times has won 106 Pulitzer Prizes, the most of any news organization...

, wrote in a blog entry in March 2009 that the decline has not been a mirror image of the Great Depression, explaining that although the decline amounts were nearly the same at the time, the rates of decline had started much faster in 2007, and that the past year had only ranked eighth among the worst recorded years of percentage drops in the Dow. The past two years ranked third however.

Financial institutions

The International Monetary Fund estimated that large U.S. and European banks lost more than $1 trillion on toxic assets and from bad loans from January 2007 to September 2009. These losses are expected to top $2.8 trillion from 2007-10. U.S. banks losses were forecast to hit $1 trillion and European bank losses will reach $1.6 trillion. The International Monetary Fund

International Monetary Fund

The International Monetary Fund is an organization of 187 countries, working to foster global monetary cooperation, secure financial stability, facilitate international trade, promote high employment and sustainable economic growth, and reduce poverty around the world...

(IMF) estimated that U.S. banks were about 60% through their losses, but British and eurozone banks only 40%.

One of the first victims was Northern Rock

Northern Rock

Northern Rock plc is a British bank, best known for becoming the first bank in 150 years to suffer a bank run after having had to approach the Bank of England for a loan facility, to replace money market funding, during the credit crisis in 2007. Having failed to find a commercial buyer for...

, a medium-sized British bank. The highly leveraged

Leverage (finance)

In finance, leverage is a general term for any technique to multiply gains and losses. Common ways to attain leverage are borrowing money, buying fixed assets and using derivatives. Important examples are:* A public corporation may leverage its equity by borrowing money...

nature of its business led the bank to request security from the Bank of England

Bank of England

The Bank of England is the central bank of the United Kingdom and the model on which most modern central banks have been based. Established in 1694, it is the second oldest central bank in the world...

. This in turn led to investor panic and a bank run

Bank run

A bank run occurs when a large number of bank customers withdraw their deposits because they believe the bank is, or might become, insolvent...

in mid-September 2007. Calls by Liberal Democrat Treasury Spokesman Vince Cable

Vincent Cable

Dr. John Vincent "Vince" Cable is a British Liberal Democrat politician and economist who is currently the Business Secretary in the coalition cabinet of David Cameron. He has been Member of Parliament for Twickenham since 1997....

to nationalise the institution were initially ignored; in February 2008, however, the British government (having failed to find a private sector buyer) relented, and the bank was taken into public hands. Northern Rock's problems

Nationalisation of Northern Rock

In 2008 the Northern Rock bank was nationalised by the British Government, due to financial problems caused by the subprime mortgage crisis...

proved to be an early indication of the troubles that would soon befall other banks and financial institutions.

Initially the companies affected were those directly involved in home construction and mortgage lending such as Northern Rock and Countrywide Financial

Countrywide Financial

, as they could no longer obtain financing through the credit markets. Over 100 mortgage lenders went bankrupt during 2007 and 2008. Concerns that investment bank Bear Stearns

Bear Stearns

would collapse in March 2008 resulted in its fire-sale to JP Morgan Chase. The financial institution crisis hit its peak in September and October 2008. Several major institutions either failed, were acquired under duress, or were subject to government takeover. These included Lehman Brothers

Lehman Brothers

, Merrill Lynch

Merrill Lynch

, Fannie Mae, Freddie Mac, Washington Mutual

Washington Mutual

Washington Mutual, Inc. , abbreviated to WaMu, was a savings bank holding company and the former owner of Washington Mutual Bank, which was the United States' largest savings and loan association until its collapse in 2008....

, Wachovia

Wachovia

Wachovia was a diversified financial services company based in Charlotte, North Carolina. Before its acquisition by Wells Fargo in 2008, Wachovia was the fourth-largest bank holding company in the United States based on total assets...

, and AIG

AIG

Credit markets and the shadow banking system

During September 2008, the crisis hit its most critical stage. There was the equivalent of a bank run

Bank run

A bank run occurs when a large number of bank customers withdraw their deposits because they believe the bank is, or might become, insolvent...

on the money market mutual funds, which frequently invest in commercial paper

Commercial paper

issued by corporations to fund their operations and payrolls. Withdrawal from money markets were $144.5 billion during one week, versus $7.1 billion the week prior. This interrupted the ability of corporations to rollover (replace) their short-term debt

Money market

The money market is a component of the financial markets for assets involved in short-term borrowing and lending with original maturities of one year or shorter time frames. Trading in the money markets involves Treasury bills, commercial paper, bankers' acceptances, certificates of deposit,...

. The U.S. government responded by extending insurance for money market accounts analogous to bank deposit insurance

Deposit insurance

Explicit deposit insurance is a measure implemented in many countries to protect bank depositors, in full or in part, from losses caused by a bank's inability to pay its debts when due...

via a temporary guarantee and with Federal Reserve programs to purchase commercial paper. The TED spread

TED spread

The TED spread is the difference between the interest rates on interbank loans and on short-term U.S. government debt . TED is an acronym formed from T-Bill and ED, the ticker symbol for the Eurodollar futures contract....

, an indicator of perceived credit risk in the general economy, spiked up in July 2007, remained volatile for a year, then spiked even higher in September 2008, reaching a record 4.65% on October 10, 2008.

In a dramatic meeting on September 18, 2008, Treasury Secretary Henry Paulson

Henry Paulson

Henry Merritt "Hank" Paulson, Jr. is an American banker who served as the 74th United States Secretary of the Treasury. He previously served as the Chairman and Chief Executive Officer of Goldman Sachs.-Early life and family:...

and Fed Chairman Ben Bernanke

Ben Bernanke

met with key legislators to propose a $700 billion emergency bailout. Bernanke reportedly told them: "If we don't do this, we may not have an economy on Monday." The Emergency Economic Stabilization Act, which implemented the Troubled Asset Relief Program (TARP), was signed into law on October 3, 2008.

Economist Paul Krugman

Paul Krugman

and U.S. Treasury Secretary Timothy Geithner explain the credit crisis via the implosion of the shadow banking system

Shadow banking system

, which had grown to nearly equal the importance of the traditional commercial banking sector as described above. Without the ability to obtain investor funds in exchange for most types of mortgage-backed securities or asset-backed commercial paper, investment banks and other entities in the shadow banking system could not provide funds to mortgage firms and other corporations.

This meant that nearly one-third of the U.S. lending mechanism was frozen and continued to be frozen into June 2009. According to the Brookings Institution

Brookings Institution

Wealth effects

There is a direct relationship between declines in wealth, and declines in consumption and business investment, which along with government spending represent the economic engine. Between June 2007 and November 2008, Americans lost an estimated average of more than a quarter of their collective net worth. By early November 2008, a broad U.S. stock index the S&P 500, was down 45% from its 2007 high. Housing prices had dropped 20% from their 2006 peak, with futures markets signaling a 30-35% potential drop. Total home equity in the United States, which was valued at $13 trillion at its peak in 2006, had dropped to $8.8 trillion by mid-2008 and was still falling in late 2008. Total retirement assets, Americans' second-largest household asset, dropped by 22%, from $10.3 trillion in 2006 to $8 trillion in mid-2008. During the same period, savings and investment assets (apart from retirement savings) lost $1.2 trillion and pension assets lost $1.3 trillion. Taken together, these losses total a staggering $8.3 trillion. Since peaking in the second quarter of 2007, household wealth is down $14 trillion.

Further, U.S. homeowners had extracted significant equity in their homes in the years leading up to the crisis, which they could no longer do once housing prices collapsed. Free cash used by consumers from home equity extraction doubled from $627 billion in 2001 to $1,428 billion in 2005 as the housing bubble built, a total of nearly $5 trillion over the period. U.S. home mortgage debt relative to GDP increased from an average of 46% during the 1990s to 73% during 2008, reaching $10.5 trillion.

To offset this decline in consumption and lending capacity, the U.S. government and U.S. Federal Reserve have committed $13.9 trillion, of which $6.8 trillion has been invested or spent, as of June 2009. In effect, the Fed has gone from being the "lender of last resort" to the "lender of only resort" for a significant portion of the economy. In some cases the Fed can now be considered the "buyer of last resort."
Economist Dean Baker

Dean Baker

explained the reduction in the availability of credit this way:

At the heart of the portfolios of many of these institutions were investments whose assets had been derived from bundled home mortgages. Exposure to these mortgage-backed securities, or to the credit derivatives used to insure them against failure, caused the collapse or takeover of several key firms such as Lehman Brothers

Lehman Brothers

, AIG

American International Group

American International Group, Inc. or AIG is an American multinational insurance corporation. Its corporate headquarters is located in the American International Building in New York City. The British headquarters office is on Fenchurch Street in London, continental Europe operations are based in...

, Merrill Lynch

Merrill Lynch

, and HBOS

HBOS

HBOS plc is a banking and insurance company in the United Kingdom, a wholly owned subsidiary of the Lloyds Banking Group having been taken over in January 2009...

European contagion

The crisis rapidly developed and spread into a global economic shock, resulting in a number of European bank failure

Bank failure

A bank failure occurs when a bank is unable to meet its obligations to its depositors or other creditors because it has become insolvent or too illiquid to meet its liabilities. More specifically, a bank usually fails economically when the market value of its assets declines to a value that is...

s, declines in various stock indexes, and large reductions in the market value of equities and commodities

Commodity

In economics, a commodity is the generic term for any marketable item produced to satisfy wants or needs. Economic commodities comprise goods and services....

.

Both MBS and CDO were purchased by corporate and institutional investors globally. Derivatives such as credit default swaps also increased the linkage between large financial institutions. Moreover, the de-leveraging

Leverage (finance)

of financial institutions, as assets were sold to pay back obligations that could not be refinanced in frozen credit markets, further accelerated the solvency crisis and caused a decrease in international trade.

World political leaders, national ministers of finance and central bank directors coordinated their efforts to reduce fears, but the crisis continued. At the end of October 2008 a currency crisis developed, with investors transferring vast capital resources into stronger currencies such as the yen, the dollar and the Swiss franc, leading many emergent economies to seek aid from the International Monetary Fund

International Monetary Fund

Global effects

A number of commentators have suggested that if the liquidity crisis continues, there could be an extended recession

Recession

In economics, a recession is a business cycle contraction, a general slowdown in economic activity. During recessions, many macroeconomic indicators vary in a similar way...

or worse. The continuing development of the crisis has prompted in some quarters fears of a global economic collapse

Economic collapse

There is no precise definition of an economic collapse. While some might consider a a severe, prolonged depression with high bankruptcy rates and high unemployment an economic collapse, others would additionally look for a breakdown in normal commerce, such as hyperinfalation, or even a sharp...

although there are now many cautiously optimistic forecasters in addition to some prominent sources who remain negative. The financial crisis is likely to yield the biggest banking shakeout since the savings-and-loan meltdown.
Investment bank UBS

UBS AG

UBS AG is a Swiss global financial services company headquartered in Basel and Zürich, Switzerland, which provides investment banking, asset management, and wealth management services for private, corporate, and institutional clients worldwide, as well as retail clients in Switzerland...

stated on October 6 that 2008 would see a clear global recession, with recovery unlikely for at least two years. Three days later UBS economists announced that the "beginning of the end" of the crisis had begun, with the world starting to make the necessary actions to fix the crisis: capital

Financial capital

injection by governments; injection made systemically; interest rate cuts to help borrowers. The United Kingdom had started systemic injection, and the world's central banks were now cutting interest rates. UBS emphasized the United States needed to implement systemic injection. UBS further emphasized that this fixes only the financial crisis, but that in economic terms "the worst is still to come". UBS quantified their expected recession durations on October 16: the Eurozone's would last two quarters, the United States' would last three quarters, and the United Kingdom's would last four quarters. The economic crisis in Iceland involved all three of the country's major banks. Relative to the size of its economy, Iceland

Iceland

Iceland , described as the Republic of Iceland, is a Nordic and European island country in the North Atlantic Ocean, on the Mid-Atlantic Ridge. Iceland also refers to the main island of the country, which contains almost all the population and almost all the land area. The country has a population...

’s banking collapse is the largest suffered by any country in economic history.

At the end of October UBS revised its outlook downwards: the forthcoming recession would be the worst since the early 1980s recession

Early 1980s recession

The early 1980s recession describes the severe global economic recession affecting much of the developed world in the late 1970s and early 1980s. The United States and Japan exited recession relatively early, but high unemployment would continue to affect other OECD nations through at least 1985...

with negative 2009 growth for the U.S., Eurozone, UK; very limited recovery in 2010; but not as bad as the Great Depression

Great Depression

.

The Brookings Institution

Brookings Institution

reported in June 2009 that U.S. consumption accounted for more than a third of the growth in global consumption between 2000 and 2007. "The US economy has been spending too much and borrowing too much for years and the rest of the world depended on the U.S. consumer as a source of global demand." With a recession in the U.S. and the increased savings rate of U.S. consumers, declines in growth elsewhere have been dramatic. For the first quarter of 2009, the annualized rate of decline in GDP was 14.4% in Germany, 15.2% in Japan, 7.4% in the UK, 18% in Latvia, 9.8% in the Euro area and 21.5% for Mexico.

Some developing countries that had seen strong economic growth

Economic growth

In economics, economic growth is defined as the increasing capacity of the economy to satisfy the wants of goods and services of the members of society. Economic growth is enabled by increases in productivity, which lowers the inputs for a given amount of output. Lowered costs increase demand...

saw significant slowdowns. For example, growth forecasts in Cambodia

Cambodia

Cambodia , officially known as the Kingdom of Cambodia, is a country located in the southern portion of the Indochina Peninsula in Southeast Asia...

show a fall from more than 10% in 2007 to close to zero in 2009, and Kenya may achieve only 3-4% growth in 2009, down from 7% in 2007. According to the research by the Overseas Development Institute

Overseas Development Institute

The Overseas Development Institute is one of the leading independent think tanks on international development and humanitarian issues. Based in London, its mission is "to inspire and inform policy and practice which lead to the reduction of poverty, the alleviation of suffering and the achievement...

, reductions in growth can be attributed to falls in trade, commodity prices, investment and remittances

Remittances

A remittance is a transfer of money by a foreign worker to his or her home country. Note that in 19th century usage a remittance man was someone exiled overseas and sent an allowance on condition that he not return home....

sent from migrant workers (which reached a record $251 billion in 2007, but have fallen in many countries since). This has stark implications and has led to a dramatic rise in the number of households living below the poverty line, be it 300,000 in Bangladesh or 230,000 in Ghana.

The World Bank reported in February 2009 that the Arab World was far less severely affected by the credit crunch. With generally good balance of payments positions coming into the crisis or with alternative sources of financing for their large current account deficits, such as remittances, Foreign Direct Investment (FDI) or foreign aid, Arab countries were able to avoid going to the market in the latter part of 2008. This group is in the best position to absorb the economic shocks. They entered the crisis in exceptionally strong positions. This gives them a significant cushion against the global downturn. The greatest impact of the global economic crisis will come in the form of lower oil prices, which remains the single most important determinant of economic performance. Steadily declining oil prices would force them to draw down reserves and cut down on investments. Significantly lower oil prices could cause a reversal of economic performance as has been the case in past oil shocks. Initial impact will be seen on public finances and employment for foreign workers.

Real gross domestic product

The output of goods and services produced by labor and property located in the United States—decreased at an annual rate of approximately 6% in the fourth quarter of 2008 and first quarter of 2009, versus activity in the year-ago periods. The U.S. unemployment

Unemployment

Unemployment , as defined by the International Labour Organization, occurs when people are without jobs and they have actively sought work within the past four weeks...

rate increased to 10.1% by October 2009, the highest rate since 1983 and roughly twice the pre-crisis rate. The average hours per work week declined to 33, the lowest level since the government began collecting the data in 1964.

Distribution of wealth

The very rich lost relatively less in the crisis than the remainder of the population, widening the wealth gap between the economic class at the very top of the demographic pyramid and everyone else beneath them. Thus the top 1% who owned 34.6% of the nation's wealth in 2007 increased their proportional share to over 37.1% by 2009.

Typical American families did not fare as well, nor did those "wealthy-but-not wealthiest" families just beneath the pyramid's top. On the other hand, half of the poorest families did not have wealth declines at all during the crisis. The Federal Reserve surveyed 4,000 households between 2007 and 2009, and found that the total wealth of 63 percent of all Americans declined in that period. 77 percent of the richest families had a decrease in total wealth, while only 50 percent of those on the bottom of the pyramid suffered a decrease.

Official economic projections

On November 3, 2008, the European Commission at Brussels

Brussels

Brussels , officially the Brussels Region or Brussels-Capital Region , is the capital of Belgium and the de facto capital of the European Union...

predicted for 2009 an extremely weak growth of GDP, by 0.1%, for the countries of the Eurozone

Eurozone

The eurozone , officially called the euro area, is an economic and monetary union of seventeen European Union member states that have adopted the euro as their common currency and sole legal tender...

(France, Germany, Italy, Belgium etc.) and even negative number for the UK (-1.0%), Ireland and Spain. On November 6, the IMF at Washington, D.C., launched numbers predicting a worldwide recession by -0.3% for 2009, averaged over the developed economies. On the same day, the Bank of England and the European Central Bank

European Central Bank

The European Central Bank is the institution of the European Union that administers the monetary policy of the 17 EU Eurozone member states. It is thus one of the world's most important central banks. The bank was established by the Treaty of Amsterdam in 1998, and is headquartered in Frankfurt,...

, respectively, reduced their interest rates from 4.5% down to 3%, and from 3.75% down to 3.25%. As a consequence, starting from November 2008, several countries launched large "help packages" for their economies.

The U.S. Federal Reserve Open Market Committee release in June 2009 stated:

Emergency and short-term responses

The U.S. Federal Reserve and central banks around the world have taken steps to expand money supplies to avoid the risk of a deflationary spiral, in which lower wages and higher unemployment lead to a self-reinforcing decline in global consumption. In addition, governments have enacted large fiscal stimulus packages, by borrowing and spending to offset the reduction in private sector demand caused by the crisis. The U.S. executed two stimulus packages, totaling nearly $1 trillion during 2008 and 2009.

This credit freeze brought the global financial system to the brink of collapse. The response of the U.S. Federal Reserve, the European Central Bank

European Central Bank

, and other central banks was immediate and dramatic. During the last quarter of 2008, these central banks purchased US$2.5 trillion of government debt and troubled private assets from banks. This was the largest liquidity injection into the credit market, and the largest monetary policy action, in world history. The governments of European nations and the USA also raised the capital of their national banking systems by $1.5 trillion, by purchasing newly issued preferred stock

Preferred stock

Preferred stock, also called preferred shares, preference shares, or simply preferreds, is a special equity security that has properties of both an equity and a debt instrument and is generally considered a hybrid instrument...

in their major banks. In October 2010, Nobel laureate Joseph Stiglitz explained how the U.S. Federal Reserve was implementing another monetary policy —creating currency— as a method to combat the liquidity trap

Liquidity trap

A liquidity trap is a situation described in Keynesian economics in which injections of cash into an economy by a central bank fail to lower interest rates and hence to stimulate economic growth. A liquidity trap is caused when people hoard cash because they expect an adverse event such as...

. By creating $600,000,000,000 and inserting this directly into banks the Federal Reserve intended to spur banks to finance more domestic loans and refinance mortgages. However, banks instead were spending the money in more profitable areas by investing internationally in emerging markets. Banks were also investing in foreign currencies which Stiglitz and others point out may lead to currency war

Currency war

Currency war, also known as competitive devaluation, is a condition in international affairs where countries compete against each other to achieve a relatively low exchange rate for their own currency. As the price to buy a particular currency falls, so to does the real price of exports from the...

s while China

China

Chinese civilization may refer to:* China for more general discussion of the country.* Chinese culture* Greater China, the transnational community of ethnic Chinese.* History of China* Sinosphere, the area historically affected by Chinese culture...

redirects its currency holdings away from the United States.

Governments have also bailed out a variety of firms as discussed above, incurring large financial obligations. To date, various U.S. government agencies have committed or spent trillions of dollars in loans, asset purchases, guarantees, and direct spending. For a summary of U.S. government financial commitments and investments related to the crisis, see CNN - Bailout Scorecard. Significant controversy has accompanied the bailout, leading to the development of a variety of "decision making frameworks", to help balance competing policy interests during times of financial crisis.

Regulatory proposals and long-term responses

United States President Barack Obama

Barack Obama

Barack Hussein Obama II is the 44th and current President of the United States. He is the first African American to hold the office. Obama previously served as a United States Senator from Illinois, from January 2005 until he resigned following his victory in the 2008 presidential election.Born in...

and key advisers introduced a series of regulatory proposals in June 2009. The proposals address consumer protection, executive pay, bank financial cushions or capital requirements, expanded regulation of the shadow banking system

Shadow banking system

and derivatives

Derivative (finance)

, and enhanced authority for the Federal Reserve to safely wind-down systemically important institutions, among others. In January 2010, Obama proposed additional regulations limiting the ability of banks to engage in proprietary trading

Proprietary trading

Proprietary trading occurs when a firm trades stocks, bonds, currencies, commodities, their derivatives, or other financial instruments, with the firm's own money as opposed to its customers' money, so as to make a profit for itself...

. The proposals were dubbed "The Volcker Rule

Volcker Rule

The Volcker Rule is a specific section of the Dodd–Frank Wall Street Reform and Consumer Protection Act originally proposed by American economist and former United States Federal Reserve Chairman Paul Volcker to restrict United States banks from making certain kinds of speculative investments that...

", in recognition of Paul Volcker

Paul Volcker

Paul Adolph Volcker, Jr. is an American economist. He was the Chairman of the Federal Reserve under United States Presidents Jimmy Carter and Ronald Reagan from August 1979 to August 1987. He is widely credited with ending the high levels of inflation seen in the United States in the 1970s and...

, who has publicly argued for the proposed changes.

The U.S. Senate passed a regulatory reform bill in May 2010, following the House which passed a bill in December 2009. These bills must now be reconciled. The New York Times provided a comparative summary of the features of the two bills, which address to varying extent the principles enumerated by the Obama administration. For instance, the Volcker Rule against proprietary trading is not part of the legislation, though in the Senate bill regulators have the discretion but not the obligation to prohibit these trades.

United States Congress response

On December 11, 2009 - House cleared bill H.R.4173 - Wall Street Reform and Consumer Protection Act of 2009.
On April 15, 2010 - Senate introduced bill S.3217 - Restoring American Financial Stability Act of 2010
Restoring American Financial Stability Act of 2010
The Dodd–Frank Wall Street Reform and Consumer Protection Act is a federal statute in the United States that was signed into law by President Barack Obama on July 21, 2010...

.
On July 21, 2010 - the Dodd-Frank Wall Street Reform and Consumer Protection Act was enacted.

Stabilization

The recession that began in December 2007 ended in June 2009, according to the U.S. National Bureau of Economic Research

National Bureau of Economic Research

The National Bureau of Economic Research is an American private nonprofit research organization "committed to undertaking and disseminating unbiased economic research among public policymakers, business professionals, and the academic community." The NBER is well known for providing start and end...

(NBER) and the financial crisis appears to have ended about the same time. In April 2009 TIME Magazine declared "More Quickly Than It Began, The Banking Crisis Is Over." The United States Financial Crisis Inquiry Commission dates the crisis to 2008. President Barack Obama

Barack Obama

declared on January 27, 2010, "the markets are now stabilized, and we've recovered most of the money we spent on the banks."

The New York Times identifies March, 2009 as the "nadir of the crisis" and notes that "Most stock markets around the world are at least 75 percent higher than they were then. Financial stocks, which led the markets down, have also led them up." Nevertheless, the lack of fundamental changes in banking and financial markets, worries many market participants, including the International Monetary Fund

International Monetary Fund

Media coverage

The financial crises have generated many articles and books outside of the scholarly and financial press, including articles and books by author William Greider

William Greider

William Greider is an American journalist and author who writes primarily about economics.His most recent book is . Before that he published The Soul of Capitalism: Opening Paths to a Moral Economy, which explores the basis and history of the corporation and how people can influence further...

, economist Michael Hudson

Michael Hudson (economist)

Michael Hudson is research professor of economics at University of Missouri, Kansas City and a research associate at the Levy Economics Institute of Bard College...

, author and former bond salesman Michael Lewis

Michael Lewis (author)

, Kevin Phillips

Kevin Phillips (political commentator)

Kevin Price Phillips is an American writer and commentator on politics, economics, and history. Formerly a Republican Party strategist, Phillips has become disaffected with his former party over the last two decades, and is now one of its most scathing critics...

, and investment broker Peter Schiff

Peter Schiff

.

In May 2010 premiered Overdose: A Film about the Next Financial Crisis, a documentary about how the financial crisis came about and how the solutions that have been applied by many governments are setting the stage for the next crisis. The film is based on the book Financial Fiasco by Johan Norberg and features Alan Greenspan

Alan Greenspan

Alan Greenspan is an American economist who served as Chairman of the Federal Reserve of the United States from 1987 to 2006. He currently works as a private advisor and provides consulting for firms through his company, Greenspan Associates LLC...

, with funding from the libertarian think tank The Cato Institute. Greenspan is responsible for de-regulating the derivatives market while chairman of the Federal Reserve.

In October 2010, a documentary film

Documentary film

Documentary films constitute a broad category of nonfictional motion pictures intended to document some aspect of reality, primarily for the purposes of instruction or maintaining a historical record...

about the crisis, Inside Job

Inside Job (film)

Inside Job is a 2010 documentary film about the late-2000s financial crisis directed by Charles H. Ferguson. The film is described by Ferguson as being about "the systemic corruption of the United States by the financial services industry and the consequences of that systemic corruption." In five...

directed by Charles Ferguson

Charles H. Ferguson

Charles Henry Ferguson is the founder and president of Representational Pictures, Inc., director and producer of No End In Sight: The American Occupation of Iraq and Inside Job , which won the Academy Award for Best Documentary...

, was released by Sony Pictures Classics

Sony Pictures Classics

Sony Pictures Classics is an art-house film division of Sony Pictures Entertainment founded in December 1991 that distributes, produces and acquires specialty films from the United States and around the world. Its co-presidents are Michael Barker and Tom Bernard...

.

Time Magazine named "25 People to Blame for the Financial Crisis"

Emerging and developing economies drive global economic growth

The financial crisis has caused the emerging and developing economies to replace advanced economies to lead global economic growth. Advanced economies accounted for only 35% of incremental global nominal GDP and 23% of incremental global GDP (PPP) while emerging and developing economies accounted for 65% of incremental global nominal GDP and 77% of incremental global GDP (PPP) from 2007 to 2011 according to International Monetary Fund

International Monetary Fund

. Emerging and developing economies are in bold.

List of 20 Largest Economies by Incremental Nominal GDP from 2007 to 2011 by the International Monetary Fund

International Monetary Fund

List of 20 Largest Economies by Incremental GDP (PPP) from 2007 to 2011 by the International Monetary Fund

International Monetary Fund

EWLINE

Rank	Country	GDP (billions of USD)	Share of Global Incremental GDP	Annualized GDP Growth
World Gross world product Gross world product is the total gross national product of all the countries in the world. This also equals the total gross domestic product. See measures of national income and output for more details...	14,331.570	100.00%	6.4%
1	Mainland China	3,494.240	24.38%	25.0%
2	United States	1,477.420	10.31%	8.4%
3	Brazil	1,139.740	7.95%	20.7%
4	Japan	1,036.140	7.23%	1.8%
European Union	985.438	6.88%	1.5%
5	India	690.569	4.82%	15.0%
6	Russia	585.200	4.08%	11.3%
7	Australia	553.746	3.86%	14.5%
8	Indonesia	402.103	2.81%	23.3%
9	Canada	334.613	2.33%	5.9%
10	Germany	300.034	2.09%	2.3%
11	Switzerland	231.780	1.62%	13.3%
12	Early Modern France	221.090	1.54%	2.1%
13	Saudi Arabia	175.095	1.22%	11.4%
14	Argentina	173.087	1.21%	16.5%
15	Iran	165.998	1.16%	13.4%
16	Mexico	149.978	1.05%	3.6%
17	South Africa	136.234	0.95%	11.9%
18	Italy	126.459	0.88%	1.5%
19	South Korea	114.608	0.80%	2.7%
20	Turkey	113.971	0.80%	4.4%
*Remaining Countries*	2,709.465	18.91%

EWLINE

Rank	Country	GDP (billions of USD)	Share of Global Incremental GDP	Annualized GDP Growth
World Gross world product Gross world product is the total gross national product of all the countries in the world. This also equals the total gross domestic product. See measures of national income and output for more details...	12,173.900	100.00%	4.6%
1	Mainland China	3,982.470	32.71%	13.6%
2	India	1,358.450	11.16%	10.9%
3	United States	1,036.140	8.51%	1.8%
European Union	949.937	7.80%	1.6%
4	Brazil	452.663	3.72%	6.1%
5	Indonesia	282.220	2.32%	8.4%
6	South Korea	268.174	2.20%	5.2%
7	Russia	260.758	2.14%	3.1%
8	Germany	245.872	2.02%	2.2%
9	Argentina	186.084	1.53%	8.9%
10	Turkey	166.360	1.37%	4.7%
11	Republic of China	165.963	1.36%	5.8%
12	Mexico	162.777	1.34%	2.7%
13	Poland	142.546	1.17%	5.7%
14	Early Modern France	142.482	1.17%	1.7%
15	Iran	139.535	1.15%	4.4%
16	Saudi Arabia	128.810	1.06%	5.9%
17	Canada	127.482	1.05%	2.5%
18	Australia	126.854	1.04%	4.0%
19	Nigeria	119.874	0.98%	10.1%
20	Egypt	111.026	0.91%	6.9%
*Remaining Countries*	2,567.360	21.09%

External links and further reading

US Financial Crisis Inquiry Commission
US Senate - Anatomy of a financial collapse- an Investigations Subcommittee report on the mortgage market, 5.5MB
Times of Crisis – Reuters: Multimedia interactive charting the year of global change
PBS Frontline – Inside the Meltdown
Credit Crisis—The Essentials topic page from The New York Times
The New York Times
The New York Times is an American daily newspaper founded and continuously published in New York City since 1851. The New York Times has won 106 Pulitzer Prizes, the most of any news organization...
How nations around the world are responding to the global financial crisis from PBS
Public Broadcasting Service
The Public Broadcasting Service is an American non-profit public broadcasting television network with 354 member TV stations in the United States which hold collective ownership. Its headquarters is in Arlington, Virginia....
In depth: Global financial crisis from the Financial Times
Financial Times
The Financial Times is an international business newspaper. It is a morning daily newspaper published in London and printed in 24 cities around the world. Its primary rival is the Wall Street Journal, published in New York City....
Timeline: Global credit crunch Published in BBC News
BBC News
BBC News is the department of the British Broadcasting Corporation responsible for the gathering and broadcasting of news and current affairs. The department is the world's largest broadcast news organisation and generates about 120 hours of radio and television output each day, as well as online...

on October 6, 2008.
Financial Crisis-IMF
Financial Crisis-World Bank Group
Global Financial Crisis-Asian Development Bank
"What Caused the Crisis": A collection of papers at the Federal Reserve Bank of St. Louis,

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