Pa

ge

1

Introduction about 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 value1.

The financial crisis of 2007–2008, initially referred

to in the media as a "credit crunch" or "credit crisis"2,

began in July 20073 when a loss of confidence by investors in the value of securitized

mortgages4 in the United States resulted in a liquidity crisis that prompted a substantial

injection of capital into financial markets by the United States Federal Reserve and the

European Central Bank.

Historical Background of Recent Global Financial Crisis

Historical background of recent financial crisis may be categorized as follows:

1. Credit Crunch & Housing Bubble: The stock price plunge and severe credit crunch we are watching today in global financial markets are byproducts of the developments in the US six years ago. In late 2001, fears of global terror attacks after 9/11 shook an already struggling US economy, one that was just beginning to come out of the recession induced by the bursting of the dotcom bubble of late 1990s.

In response, during 2001, the Federal Reserve, the US central bank, began cutting interest rates dramatically to encourage borrowing, which spurred both consumption and investment spending. As lower interest rates worked their way into the economy, the real-estate market began to get itself into frenzy. The number of homes sold and the prices they sold for increased dramatically, beginning in 2002. At the time, the rate on a 30-year fixed rate mortgage was at the lowest levels seen in nearly 40 years.

Subprime and similar mortgage originations in the US rose from less than 8% of all mortgages in 2003 to over 20% in 2006.

The crisis began with the bursting of the US housing bubble and high default rates on subprime and adjustable rate mortgages, beginning in approximately 2005-2006. For a number of years prior to that, declining lending standards, an increase in loan incentives such as easy initial terms, and a long-term trend of rising housing prices had encouraged borrowers to assume difficult mortgages in the belief they would be able to quickly refinance at more favorable terms.

1 http://en.wikipedia.org/wiki/Financial_crisis 2 Larry Elliott (August 5 2008). "Credit crisis - how it all began suddenly, one August day last

year shook the world, turning an Edwardian summer of prosperity into a grim financial crisis". The Guardian

3 Wall Street Journal. "TED Spread spikes in July 2007". Wall Street Journal 4 Floyd Norris (August 10, 2007). "A New Kind of Bank Run Tests Old Safeguards". The New York

Times

Pa

ge

2

2. Rise in Interest Rate & Housing Price: However, once interest rates began to rise and housing prices started to drop in 2006-2007 in many parts of the US, refinancing became more difficult. Default and foreclosure activity increased dramatically as easy initial terms expired, home prices failed to go up as anticipated, and adjustable rate mortgage interest rates reset higher. Foreclosures accelerated in the United States in late 2006 and triggered a global financial crisis through 2007 and 2008.

3. Fall of Construction & Mortgage-lending Institutions: Initially the companies affected were those directly involved in home construction and mortgage lending. Financial institutions, which had engaged in the securitization of mortgages, fell prey subsequently. Bear Stearns’ stock price fell from the record high $154 to $3 which was the acquisition price by JP Morgan Chase, subsequently the acquisition price was agreed on $10 between the US government as well as JP Morgan. On July 11, 2008, the largest mortgage

lender in the US, IndyMac Bank, collapsed. Government

attempted to save mortgage lenders Fannie Mae and Freddie Mac, which it did by placing

the two companies into federal conservatorship on September 7, 2008 after the crisis

further accelerated in late summer.

4. Fall of Non-mortgage lending Financial Institutions: It then began to affect the general availability of credit to non-housing related businesses and to larger

financial institutions not directly connected with mortgage lending. At the heart of many of these institution's portfolios 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, threatened an increasing number of firms such as Lehman Brothers5, AIG, Merrill Lynch, and HBOS6. Other

firms that came under pressure included Washington Mutual7, the largest savings and loan association in the United States, and the remaining large investment firms, Morgan Stanley and Goldman Sachs8.

5 "Lehman Files for Bankruptcy; Merrill Is Sold" article by Andrew Ross Sorkin in The New York

Times September 14, 2008 6 "Pain Spreads as Credit Vise Grows Tighter" article by Louis Uchitelle in The New York Times

September 18, 2008 7 "Washington Mutual Is Said to Consider Sale" article by Geraldine Fabrikant in The New York

Times September 17, 2008 8 "As Fears Grow, Wall St. Titans See Shares Fall" article by Ben White and Eric Dash in The New

York Times September 17, 2008

Pa

ge

3

5. Initiating Big-budget Supportive Program by some Governments: Many financial institutions in Europe also faced the liquidity problem that they needed to raise their capital adequacy ratio. As the crisis developed, stock markets fell worldwide, and global financial regulators attempted to coordinate efforts to contain the crisis. The US took $700 billion bailout plan and the UK launched a £500 billion bailout plan aimed to injecting capital into the financial system. The British government nationalized most of the financial intuitions in trouble. Many European governments followed as well as the US government. In the Eastern European economies of Poland, Hungary, Romania, and Ukraine the economic crisis was characterized by difficulties with loans made in hard currencies such as the Swiss franc. As local currencies in those countries lost value making payment on such loans became progressively difficult.

As the financial panic developed during September and October, 2008 there was a "flight to quality" as investors sought safety in U.S. treasury bonds, gold, and strong currencies such as the dollar and the yen. This currency crisis threatened to disrupt international trade and produced strong pressure on all world currencies.