Financial Crisis in 2008

Group members:
Gohar Ali Meer

13130020

Hamza Shamshad

13130021

Esha Humayon

11108229

Group Assignment:

01

Submitted to:
Prof. Qasim Nasim Mir

Gift University

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Financial Crisis in 2008

Reasons of financial crisis in 2008

In 2008 the world economy faced its most dangerous crisis since the Great Depression of the
1930s. The contagion, which began in 2007 when sky-high home prices in the United States
finally turned decisively downward, spread quickly, first to the entire U.S. financial sector and
then to financial markets overseas. The casualties in the United States included:
a) The entire investment banking industry
b) The biggest insurance company
c) The two enterprises chartered by the government to facilitate mortgage lending
d) The largest mortgage lender
e) The largest savings and loan
f) Two of the largest commercial banks.
The carnage was not limited to the financial sector, however, as companies that
normally rely on credit suffered heavily. The American auto industry, which pleaded for a federal
bailout, found itself at the edge of an abyss. Still more ominously, banks, trusting no one to pay
them back, simply stopped making the loans that most businesses need to regulate their cash
flows and without which they cannot do business. Share prices plunged throughout the world
the Dow Jones Industrial Average in the U.S. lost 33.8% of its value in 2008and by the end of
the year, a deep recession had enveloped most of the globe. In December the National Bureau of
Economic Research, the private group recognized as the official arbiter of such things,
determined that a recession had begun in the United States in December 2007, which made this
already the third longest recession in the U.S. since World War II.
Crisis in the American housing market:
It began with mortgage dealers who issued mortgages with terms unfavorable to borrowers, who
were often families that did not qualify for ordinary home loans. Some of these so-called
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Financial Crisis in 2008

subprime mortgages carried low interest rates in the early years that ballooned to double-digit
rates in later years. Some included prepayment penalties that made it prohibitively expensive to
refinance. These features were easy to miss for first-time home buyers, many of them
unsophisticated in such matters, who were beguiled by the prospect that, no matter what their
income or their ability to make a down payment, they could own a home.
Mortgage lenders did not merely hold the loans, content to receive a monthly
check from the mortgage holder. Frequently they sold these loans to a bank or to Fannie Mae or
Freddie Mac, two government-chartered institutions created to buy up mortgages and provide
mortgage lenders with more money to lend. Fannie Mae and Freddie Mac might then sell the
mortgages to investment banks that would bundle them with hundreds or thousands of others into
a mortgage-backed security that would provide an income stream comprising the sum of all of
the monthly mortgage payments. Then the security would be sliced into perhaps 1,000 smaller
pieces that would be sold to investors, often misidentified as low-risk investments.
As long as housing prices kept rising, everyone profited. Mortgage holders with
inadequate sources of regular income could borrow against their rising home equity. The
agencies that rank securities according to their safety (which are paid by the issuers of those
securities, not by the buyers) generally rated mortgage-backed securities relatively safethey
were not. When the housing bubble burst, more and more mortgage holders defaulted on their
loans. At the end of September, about 3% of home loans were in the foreclosure process, an
increase of 76% in just a year. Another 7% of homeowners with a mortgage were at least one
month past due on their payments, up from 5.6% a year earlier. By 2008 the mild slump in
housing prices that had begun in 2006 had become a free fall in some places. Many other
Congressmen also have demanded an audit of the FED and this has been partially done. It was
discovered that over a trillion dollars was given to banks, many of them foreign, in the aftermath
of the Financial Crisis of 2008.

Causes of Financial crisis in 2008:

The reasons for this crisis are varied and complex. The crisis can be attributed to a number
of factors pervasive in both the housing and credit markets, which developed over an extended
period of time. There are many different views on the causes, including the inability of
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Financial Crisis in 2008

homeowners to make their mortgage payments, poor judgment by the borrower and/or the lender,
speculation and overbuilding during the boom period, risky mortgage products, high personal
and corporate debt levels, complex financial innovations that distributed and perhaps concealed
default risks, central bank policies, and government regulation (or alternatively lack thereof). In
its 15 November 2008 Declaration of the Summit on Financial Markets and the World
Economy, leaders of the Group of 20 cited the following causes:
During a period of strong global growth, growing capital flows, and prolonged
stability earlier this decade, market participants sought higher yields without an adequate
appreciation of the risks and failed to exercise proper due diligence. At the same time, weak
underwriting standards, unsound risk management practices, increasingly complex and opaque
financial products, and consequent excessive leverage combined to create vulnerabilities in the
system. Policy-makers, regulators and supervisors, in some advanced countries, did not
adequately appreciate and address the risks building up in financial markets, keep pace with
financial innovation, or take into account the systemic ramifications of domestic regulatory
actions.

Financial sector downturn:

Financial institutions from around the world have recognized subprime-related losses and
write-downs exceeding U.S. $501 billion as of August 2008. Profits at the 8,533 U.S. banks
insured by the FDIC declined from $35.2 billion to $646 million (89%) during the fourth
quarter of 2007 versus the prior year, due to soaring loan defaults and provisions for loan
losses. It was the worst bank and thrift quarterly performance since 1990. For all of 2007,
these banks earned approximately $100 billion, down 31% from a record profit of $145
billion in 2006. Profits declined from $35.6 billion to $19.3 billion during the first quarter of
2008 versus the prior year, a decline of 46%.
The financial sector began to feel the consequences of this crisis in February 2007
with the $10.5 billion write-down of HSBC, which was the first major CDO or MBO related
loss to be reported. During 2007, at least 100 mortgage companies either shut down,
suspended operations or were sold. Top management has not escaped unscathed, as the CEOs
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Financial Crisis in 2008

of Merrill Lynch and Citigroup were forced to resign within a week of each other. [124] various
institutions followed up with merger deals.

Indirect economic effects:

The subprime crisis had a series of other economic effects. Housing price declines left
consumers with less wealth, which placed downward pressure on consumption. Certain
minority groups received a higher proportion of subprime loans and experienced a
disproportional level of foreclosures. Home related crimes including arson increased. Job losses
in the financial sector were significant, with over 65,400 jobs lost in the United States as of
September 2008.
Many renters became innocent victims, often evicted from their homes without
notice due to foreclosure of their landlords property. In October 2008, Tom Dart, the elected
Sheriff of Cook County, Illinois, criticized mortgage companies for their actions, and
announced that he was suspending all foreclosure evictions.
The sudden lack of credit also caused a slump in car sales. Ford sales in October 2008 were
down 33.8% from a year ago, General Motors sales were down 15.6%, and Toyota sales had
declined 32.3%. One in five car dealerships are expected to close in fall of 2008.

Asia and the financial crisis

Countries in Asia are increasingly worried about what is happening in the West. A
number of nations urged the US to provide meaningful assurances and bailout packages for
the US economy, as that would have a knock-on effect of reassuring foreign investors and
helping ease concerns in other parts of the world. Many believe Asia was sufficiently decoupled from the Western financial systems, but this crisis has shown that this is not the case,
at least not yet. Many Asian countries have seen their stock markets suffer and currency
values going on a downward trend.
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Financial Crisis in 2008

As many nations in the region are seeing rapid growth and wealth creation, there is
enormous investment in Western countries, and therefore, a lot of exposure to problems, too.
In addition, there is increased foreign investment, mostly from the West in Asia. Asian
products and services are also global, and a slowdown in wealthy countries means increased
chances of a slowdown in Asia and the risk of job losses. Asia has not had a subprime
mortgage crisis like many nations in the West, but the increasingly inter-connected world
means there are always knock-on effects.

The financial crisis and wealthy countries:

Many have blamed the greed of Wall Street for causing the problem in the first
place because it is in the US that the most influential banks, institutions and ideologues that
pushed for the policies that caused the problems are found.
The crisis became so severe that after the failure and buyouts of major institutions,
the Bush Administration offered a $700 billion bailout plan for the US financial system. This
bailout package was controversial because it was unpopular with the public, seen as a bailout
for the culprits while the ordinary person would be left to pay for their folly. The initial
rejection at the US House of Representatives, because of this, sent shock waves around the
world. It took a second attempt to pass the plan, but with add-ons to the bill to get the
additional congressmen and women to accept the plan.
Americans have lost faith not only in the [Bush] administration, but in its
economic philosophy: a new corporate welfares behind free-market ideology; another version
of trickle-down economics, where the hundreds of billions to Wall Street that caused the
problem were supposed to somehow trickle down to help ordinary Americans. Trickle-down
hasnt been working well in America over the past eight years.
The very assumption that the rescue plan has to help is suspect. After all, the IMF
and US treasury bail-outs for Wall Street 10 years ago in Korea, Thailand, Indonesia, Brazil,
Russia and Argentina didnt work for those countries, although it did enable Wall Street to get

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back most of its money. The taxpayers in these other poor countries picked up the tab for the
financial markets mistakes. This time, it is American taxpayers who are being asked to pick
up the tab. And thats the difference. For all the rhetoric about democracy and good
governance, the citizens in those countries didnt really get a chance to vote on the bail-outs
In environmental economics, there is a basic concept called the polluter pays
principle. It is a matter of fairness, but also of efficiency. Wall Street has polluted our
economy with toxic mortgages. It should now pay for the cleanup.

The financial crisis and the developing world:

For the developing world, the rises in food prices as well as the knock-on effects
from the financial instability and uncertainty in industrialized nations are having a
compounding effect. High fuel prices, soaring commodity prices together with fears of global
recession are worrying many developing country analysts. Summarizing a United Nations
Conference on Trade and Development report, the Third World Network notes the impacts the
crisis could have around the world, especially on developing countries that are dependent on
commodities for import or export: Uncertainty and instability in international financial,
currency and commodity markets, coupled with doubts about the direction of monetary policy
in some major developed countries, are contributing to a gloomy outlook for the world
economy and could present considerable risks for the developing world, the UN Conference
on Trade and Development (UNCTAD)
Market liberalization and privatization in the commodity sector have not resulted
in greater stability of international commodity prices. There is widespread dissatisfaction with
the outcomes of unregulated financial and commodity markets, which fail to transmit reliable
price signals for commodity producers. In recent years, the global economic policy
environment seems to have become more favorable to fresh thinking about the need for
multilateral actions against the negative impacts of large commodity price fluctuations on
development and macroeconomic stability in the world economy.

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Financial Crisis in 2008

The financial crisis and wealthy countries

Many have blamed the greed of Wall Street for causing the problem in the first place
because it is in the US that the most influential banks, institutions and ideologues that pushed
for the policies that caused the problems are found. The crisis became so severe that after the
failure and buyouts of major institutions, the Bush Administration offered a $700 billion
bailout plan for the US financial system.
Americans have lost faith not only in the [Bush] administration, but in its economic
philosophy: a new corporate welfares masquerading behind free-market ideology; another
version of trickle-down economics, where the hundreds of billions to Wall Street that caused
the problem were supposed to somehow trickle down to help ordinary Americans. Trickledown hasnt been working well in America over the past eight years.
The very assumption that the rescue plan has to help is suspect. After all, the IMF and US
treasury bail-outs for Wall Street 10 years ago in Korea, Thailand, Indonesia, Brazil, Russia
and Argentina didnt work for those countries, although it did enable Wall Street to get back
most of its money. The taxpayers in these other poor countries picked up the tab for the
financial markets mistakes. This time, it is American taxpayers who are being asked to pick
up the tab. And thats the difference. For all the rhetoric about democracy and good
governance, the citizens in those countries didnt really get a chance to vote on the bail-outs
In environmental economics, there is a basic concept called the polluter pays principle. It is a
matter of fairness, but also of efficiency. Wall Street has polluted our economy with toxic
mortgages. It should now pay for the cleanup.

Possible Solutions to the Crisis:

Bailout of the markets:
There are perhaps other solutions to the crisis besides a massive bailout of the
markets. One simple policy would be to nationalize the depository institutions of the failed

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corporate holding companies, and simply let the holding companies and all other failed
institutions go bankrupt and default on their credit default swaps. The nationalized banks could
then go back to making loans as they did in the old days, having real human beings make creditgranting decisions. In addition, nationalized banks could choose to take controlling equity
positions in borrowing companies in default on their loans and effectively nationalize them in
order to enable them to continue to operate (and maintain some production and employment) if
they have some chance of recovery. The cost of this policy to taxpayers might be rather small,
especially since most of the losses on the defaulting credit default swaps would then either be
offsetting or be incurred by investors like hedge funds. In addition, given that the current massive
rescue operations dont seem to be successful in averting an economic downturn, it is unclear the
need to rescue many of the failed financial institutions.

Mortgage crisis:
The real estate and mortgage crisis itself could possibly be resolved by allowing
defaulting mortgagors to refinance with shared appreciation mortgages (SAMs) that would lower
their payments in return for the lending institution receiving a share in the future appreciation on
the home. The SAMs could possibly be standardized to both reduce legal costs and also
potentially create a secondary market for them in the form of SAM pools in which investors
seeking diversification into residential real estate might be interested. By replacing foreclosure
solutions with SAMs, fewer homes would be put on the market for sale, thereby reducing the
downward pressure on real estate prices.

Enhance profitability:
Another policy that might enhance profitability and help reverse the ongoing
economic decline would be to have cases of defaults on secured consumer loans (such as for
autos or homes) result in possible renegotiation of both the loan terms and the collateral in a
unique way. For instance, instead of repossessing cars of defaulting auto loan borrowers, a
cheaper car (or even clunker trade-ins) could be offered in exchange for the existing, more
valuable collateral, and the borrower would have lower (and potentially more manageable
payments as a result. The same could be done with respect to replacing foreclosures with trading

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defaulting mortgagors down to smaller houses with lower payments (and such programs could be
combined with SAM participation by the lender to further lower periodic payments).

Conclusion:
By analyzing the root causes of the financial crisis, it is possible to estimate the costs of
resolving that crisis utilizing current policies of bailing out investors who made poor investment
decisions. Although the cost of the bailout may be staggering, cheaper solutions appear to exist.
In any event, it would seem imperative that the financial managers of the future be better
educated in the art of credit analysis.

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