Crash of 2008

Template:TOC-right The current global financial crisis, which we are provisionally calling the Crash of 2008, is now very severe. Some analysts say it could be nearly as deep as the crash of 1929, which was the forerunner of the Great Depression. The present crisis began with American banking failures and near-failures, especially those of Fannie Mae and Freddie Mac, caused primarily by the subprime mortgages crisis but has now spread rapidly to affect diverse financial organisations and ordinary citizens throughout the world, and is expected to contribute to the severity of the developing recession of 2008.

"What is the nature of the crisis?" asks the Nobel Prize-winning columnist Paul Krugman of the New York Times on the same day that he was named the recipient of the honor. He explains it as:

The details can be insanely complex, but the basics are fairly simple. The bursting of the housing bubble has led to large losses for anyone who bought assets backed by mortgage payments; these losses have left many financial institutions with too much debt and too little capital to provide the credit the economy needs; troubled financial institutions have tried to meet their debts and increase their capital by selling assets, but this has driven asset prices down, reducing their capital even further.

See the glossary for definitions of the terms shown in italics in this article.

See the Timeline subpage for outlines the major events of the crisis and links to contemporary news announcements.

The crisis

A number of the world’s banks have failed and many are in severe financial difficulties as result of making bad investments with borrowed money. As a result, many prospective housebuyers are unable to get mortgages, many companies are finding it hard to borrow the money that they need, and many investors have lost confidence in companies’ shares. Uncertainties about their financial prospects have prompted people to cut back on their spending, and the crash is developing into a world recession.

Explanations

A widely-held explanation of the crash treats it as a fallout from the United States subprime mortgages crisis. For example, the explanation offered in September 2008 by the United States government can be summarised as follows:

Inflows of money from abroad -- along with low interest rates -- enabled more United States consumers and businesses to borrow money. Easy credit -- combined with the faulty assumption that house prices would continue to rise -- led mortgage lenders there to approve loans without due regard to ability to pay, and borrowers to take out larger loans than they could afford. Optimism about prices also led to a boom in which more houses were built than people were willing to buy, so that prices fell and borrowers - with houses worth less than they expected and payments they could not afford - began to default. As a result, holders of mortgage-backed securities began to incur serious losses, and those securities became so unreliable that they could not be sold. Investment banks were consequently left with large amounts of unsaleable assets, and many failed to meet their financial obligations. Arrangements for inter-bank lending went out of use, and banks through out the world cut back upon lending .

An alternative put forward by a former member of the Bank of England's monetary policy committee, portrays the crisis as "an accident waiting to happen" that was triggered by the subprime crisis, but could have been triggered by any of a variety of events. His alternative explanation can be summarised as follows:

International organisations including the International Monetary Fund, and the Bank for International Settlements, and most central banks had long been warning about a serious underpricing of risk throughout the financial system. A general belief had arisen among bankers that if their bank got into trouble, their central bank would see it as a threat to the system and act to protect them from losses. Mistaken risk assessments by banks and their regulators may have been partly due to measurement difficulties arising from the concealment of relevant information. The failure of banking regulators to take action to avert the resulting danger may have been because they lacked the necessary regulatory instruments, or it may have been due to a lack of will. Central banks would have been reluctant to take corrective action by reducing their base rates because such action might confict with action to combat inflation. .

This explanation thus attributes the crisis to a variety of possible causes, including shortcomings of the regulatory systems, management failures by investment banks, and the conduct of banking regulators.

Neither explanation excludes the possibility that the severity of the eventual crisis might have been increased by factors other than those held to be directly responsible. The factors that have contributed to the crisis are well known although there is no consensus concerning their relative importance.

Contributory factors

Regulation

The fact that banks' assets, (which consist mainly of loans) amount typically to twenty times the value of their shares, makes them especially vulnerable to falls in the value of those assets. Governments have long been aware of the danger that a loss of confidence following the failure of one bank could lead to the failure of others, and eventually to "systemic failure" of the entire financial system. To limit that danger, they have traditionally required banks to limit the extent to which their loans exceed the funds provided by their shareholders by the imposition of minimum "reserve ratios" (see glossary) and have placed various other restrictions upon their activities. In the 1980s, however, it was widely considered that those regulations were imposing excessive economic penalties, and there was a general move toward "deregulation" . Restrictions that had prevented investment banks from broadening their activities to include branch banking, insurance or mortgage lending were dropped, and reserve requirements were relaxed or removed. In the following years there were major changes to banking practices, and they were followed by a series of banking crises . A study for the Bank for International Settlements later concluded that deregulation had left Spain, Norway, Sweden and the United States with regulatory systems that had been ill-prepared for the banking crises that they then encountered .

In 1974 the governors of the central banks of the Group of Ten leading industrial countries had set up The Basel Committee for Banking Supervision to coordinate precautionary banking regulations , and in 1988, concern about the increased danger of systemic failure led that committee to publish a set of regulatory recommendations that related a bank's required reserve ratio to the riskiness of its loans . In 1999 further concern about the danger of instability led to the creation of the Financial Stability Forum to promote information exchange and international co-operation in financial supervision and surveillance. In 2004, the Basel Committee published revised recommendations known as Basel II intended to require banks to take more detailed account of the riskiness of their loans.

Other financial institutions are regulated by national authorities, including the Securities and Exchange Commission in the United States, and the Financial Services Authority in the United Kingdom. Until recently, however, restricted-membership hedge funds have escaped regulation, and those that are registered offshore continue to do so.

Financial innovation

Among major changes in banking practice that have developed since deregulation have been the growth of securitisation, meaning the conversion of their loans into graded packages of bonds; and increased use of the strategy known as "originate and distribute", under which such bonds were sold to pension funds, insurance companies and other banks. The latter procedure removed the loans from the originating banks' balance sheets (thus improving their reserve ratios), but continued to be their financial responsiblity when – as often happened – they were transfered to their own hedge funds and to their specially-created structured investment vehicles.

A longer-term development has been a gradual change in the funding of lending, away from liquid assets such as short term government bonds to private sector assets such as residential mortgages; also, there has been a more recent trend toward the use of short-term interbank and money market borrowing (see glossary) to pay for long-term loans.

A parallel development was a massive expansion of the unregulated organisations known as hedge funds – to the point at which they are estimated to have accounted for 40 to 50 per cent of stock exchange activity by 2005 - many of which dealt in high-risk, high-return investments, and some of which used borrowed money amounting to over twenty times their capital.

Attitudes to risk

By early 2007 the regulatory authorities were expressing increased concern about banking attitudes to risk . According to the Financial Stability Forum, there had been an expansion "on a dramatic scale" of what they described as the "global trend of low risk premia and low expectations of financial volatility" . In their view, both the banks and the rating agencies had underestimated the risks to the banks' off-balance sheet vehicles that would result from an economic downturn, and the banks had underestimated the risks arising from their commitment to those vehicles. That had been due partly to the use of standard risk-management tools that were unsuitable for the assessment of securitised products when under stress, partly to difficulties of access to information, and partly to financial incentives to fund managers that failed to take account of inadvisable risk-taking.

The subprime mortgage crisis

Serious problems in the United States subprime mortgage market emerged in 2005, and arrears and defaults grew throughout 2006. By the end of 2006 it was estimated that over two million households had either lost their homes or would do so in the course of the following two years , and that one in five subprime mortgages that had been taken out in the previous two years would end in foreclosure. The origins and causes of those problems are described in the article on the subprime mortgages crisis. Their consequences for the financial system arose from their effects upon the holders of mortgage-backed securitised products. Those products had been divided according to risk into a range of "tranches", each of which had been sold to a different category of investor, with the riskiest usually going to hedge-funds and others often going to pension funds and to banks' structured investment vehicles. An early sign of distress in the financial markets was the reported burden placed upon the Bear Stearns investment bank in June 2007 by the need to rescue two of its hedge funds. By that time it was clear that the US housing boom had ended, and with falling house prices, there were accelerating mortgage foreclosures. In July, two highly-respected credit rating agencies (Moodys and Standard and Poor) downgraded hundreds of subprime mortgage-backed securities - often by two or three rating categories, and commenced a review of their rating methods. A rumour circulated that higher-grade tranches were also affected and the mood of uncertainty spread from the subprime market to affect the markets for all types of asset-backed securities.

Consequences

The credit crisis

On 9th August 2007, a French investment bank, BNP Paribas, suspended withdrawals from three of its hedge funds on the grounds that it had become impossible to value their mortgage-backed assets. That announcement was immediately followed by the virtual closure of the interbank markets that banks had used to borrow from each other. Banks that had relied upon that source for short-term funding found themselves in difficulties. An early victim was the UK's Northern Rock bank, which had relied upon those sources for 80 per cent of its funding. It was supported by short-term loans from the Bank of England, but news of that support panicked its depositors and provoked a traditional "run on the bank" as they rushed to withdraw their deposits. The crisis was further aggravated by banks' attempts to restore their reserve ratios after global capital writeoffs of about $500 billion, and by the middle of 2008 it was being said that "everyone wants to borrow and no-one wants to lend". In September 2008 a further source of credit dried up as the money market took fright after suffering unprecedented losses from the bankruptcy of Lehman Brothers. Commercial companies other than banks came to be affected with the abandonment of the practice of rolling over maturing loans; and, by September, even major firms such as AT&T were finding it impossible to borrow money by selling their commercial paper that was repayable after periods longer than a day. Prospective householders were also affected as mortgage approvals plummetted.

Economic costs

It will be difficult to distinguish the economic consequences of events in the financial markets from those of the markets for food and fuel, but there can be no doubt that they made matters worse. It can be argued that fall in house prices was no more than the end of a speculative bubble, but it is safe to assume that it hastened the process and added greatly to its costs. The full story is unlikely to become apparent for some years, but the major falls in investor, consumer and business confidence that occurred in 2008 prompted forecasts of substantial reductions in economic growth in all developed economies. But, although they consider the financial crisis to be broadly comparable with that of 1929, forecasters do not anticipate a downturn as severe or prolonged as the Great Depression, presumably because they are confident that the damaging policy responses of the 1930s will not be repeated.

Remedies

Rescue

In the early stages of the crisis, the responses of governments and financial regulators were influenced by reluctance to reinforce the moral hazard under which the expectation of rescue had encouraged risk-taking. Where very large financial institutions were concerned, however, that consideration was often outweighed by fear of "systemic failure", and that fear eventually became the dominant influence on policy. Early policy changes included a relaxation of the conditions and terms of routine short-term loans from central banks' discount windows, and the more liberal exercise of their emergency powers to act as "lenders of the last resort" . Later measures included support to the money markets by the United States Government, widespread attempts to restore general levels of financial liquidity and provision of additional capital to a series of failing banks.

Those proposals had little effect upon confidence and, towards the end of September it became evident to the United States authorities that it would not be sufficient to improve liquidity, nor to continue with ad hoc bank rescues. After initial misgivings, the Congress came to accept that the restoration of confidence depended upon the wholesale removal of "toxic assets" from the financial system, and on 3rd October it approved the $700 billion "Paulson Plan" which gave the Treasury the necessary powers. A few days later, the British government announced a £500 billion rescue scheme including powers to take equity stakes in ailing banks and an undertaking to guarantee interbank loans (that came to be known as the "Brown plan"); and a group of central banks announced a coordinated half per cent cut in their discount rates.

On October 10th the finance ministers of the Group of Seven leading industrial countries agreed a broadly-stated "action plan" but failed to state their intention in concrete terms, and the market response was negative. However, in a reversal of his former intentions, the United States Treasury Secretary subsequently indicated a willingness to extend the "Paulson Plan" to include the acquisition of equity in US banks , and, following a recommendation by Paul Krugman , plans were reported to have been set in motion to buy equity stakes in nine US banks. On the 12th of October, European Union leaders also agreed to pursue a rescue programme based upon the Brown plan, a decision that elicited the first positive response from the stock markets . On October 14th 2008, President Bush formally announced plans both to purchase equity in US banks, and to guarantee their loans , which was followed in the next week by signs of recovery in the interbank and money markets.

(An account of the subsequent development and implementation of rescue plans is to be included in the article on bank failures and rescues).

Reform

The crippling of the world financial system by a minority of defaults in a small corner of the United States economy has been seen as an reminder of that system's inherent instability. The debate about measures to reduce that instability may be prolonged, but some proposals have already been put forward. In April 2008 the Financial Stability Forum attributed the crisis to shortcomings in underwriting, firms' risk management practices, investor diligence, credit agencies' performance, staff incentives, disclosure practices, feedbacks between valuation and risk-taking, and regulatory effectiveness. They recommended regulatory changes under the headings of: strengthened prudential oversight of capital, liquidity and risk management, enhanced transparency and valuation, changes in the roles and uses of credit ratings, strengthening of the authorities’ responsiveness to risks, and robust arrangements for dealing with stress in the financial system.

(An account of further proposals for the reform of banking supervision is to appear in the article on banking)

References

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