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CURRENT GLOBAL FINANCIAL CRISIS & ITS
IMPLICATION TO INTERNATIONAL FINANCIAL
INSTITUTION: THE CASE OF US REGION
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1.0 Abstract
The current economy situation of United States towards the current global financial crisis that
affected entire country in the whole world with the factor of current global financial crisis, the
implication into international financial institution, the effect into International Financial Institution
and the government give responses towards the current global financial crisis and International
Financial Institution. The financial institution crisis hit its peak in September and October 2008.
The global financial crisis in US also affected to International Finance Corporate (IFC).
2.0 Introduction.
In the late 1920s, US were experienced with the Great Depression where stock market booms.
Great Depression was series of banking in the US beginning in October 1930 were not
successfully allayed by the Federal Reserve (Friedman and Schwartz, 1971) and turned to the
bad situation. The depression was experienced around the world by the fixed exchange rate
links of the gold exchange standard and numerous protectionist measures. Many countries
across the world were finally hit by debt and currency crises. After WWII, the world economy in
stabile because of Bretton Woods (BW) system where the currencies were kept fixed, capital
controls were widespread and financial regulation was strictly designed to prevent a repeat of
the financial disturbance in the interwar period. Bretton Woods (BW) systems were applied in
1971 and show that the capital flows surged. In addition, rate of inflation was high, and controls
on the financial system began to collapse and financial crisis problem unfortunate comeback. It
resulted in the collapse of large financial institutions, the bailout of banks by national
governments and decline in stock markets which suffered around the world. In whole regions,
the housing market also suffered in 2007 caused the values of securities tied to U.S. real estate
pricing decline and damaging financial institutions globally, resulting in evictions, continued
unemployment and foreclosures.
Late 2000s the "Great Recession" was emerged in 2007 appears at the lowest level,
although unemployment continues to increase. Many small banks and households’ still face
bigger problems in bring back their balance sheets. High rates of home foreclosures happened
with combination of the unemployment with sub-prime loans. The Great Recession has
affected the whole world economy, with higher effect in some countries than others. The U.S.
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economy has declined by 1.0% in the second quarter, much less than the 6.4% decline in the
first quarter. The Great Recession ended in the U.S. in mid 2009. Here the revolution during
2007 until 2009 toward U.S. In 2007, sub-prime mortgages was declined the US debt status
and be last point. On 9 August 2007, the seizure in the banking system was happened which
triggered by BNP Paribas. BNP Paribas announcing that it was stop their activity especially in
hedge funds which included three in US mortgage debt. This moment it became clear that
there were tens of trillions of dollars worth of derivatives swilling round which were worth was
unexpected by the banker. On 15 September 2008, financial crisis to come to U.S and took a
year only. For example, US government allowed the investment bank Lehman Brothers to go
bankrupt and assumed that intervention from governments can bail out any bank that got into
serious trouble. The U.S government finding buyer from Bear Stearns whiles the UK had
nationalized Northern Rock. When Lehman Brothers was bankruptcy, they assume that all big
banks will bankruptcy because more risky. Within a month, the assumptions were truth and
forced western governments to injected larger sums of capital into their banks to prevent the
bank’s collapse. The banks were rescued in short period of time, but it was too late to prevent
the global economy from going into fall. Credit flows to the private sector were retarded. This is
because consumer and business decrease confidence. After a period of high oil prices, it’s
come to persuaded central banks to keep interest rates high to against inflation rather than to
cut them in anticipation of the financial crisis spreading to the real economy. On 2 April 2009,
G20 group of developed and developing nations at London world leaders committed
themselves to a $5tn (£3tn) fiscal development, an extra $1.1tn of resources to help the
International Monetary Fund and other global institutions increase jobs and growth, and to
reform of the banks.
On 9 May 2010 it’s be focus of concern switched from the private sector to the public
sector because the IMF and the European Union declare they would supply fund to help
Greece. Greece had problems as it covered its public finances and facing difficult stages in
collecting taxes, but other countries started to become worry about the size of Greece budget
deficits. It’s affecting policy decisions in the UK, the euro zone and, most recently in the US.
The morphing of a private debt crisis into a sovereign debt crisis that was complete when the
rating agency, S&P, waited for Wall Street to shut up shop in weekend before declared that
America's debt no longer is classed as top-notch triple A. it’s become worst time and the
biggest sell-off in stock markets since late 2008. The US is drowning in negative equity and
foreclosed homes were terrible news for Barack Obama because not delivered economic
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recovery. Fiscal policy will be tightened over the coming months as tax breaks expire and
public spending is cut. There will be a long period of weak growth and high unemployment. The
banks pay down the excessive levels of debt collected in the bubble years and the global
economy will be decline back into recession.
3.0 Scope of study
The scope of study is reviews of the current economy situation of United States towards the
current global financial crisis that affected entire country in the whole world. In this research we
want to know the implication of United States to the International Financial Institution that
including the implication, effect and government responses whether US recover or not based
on factors in current global financial crisis such as subprime mortgage, asset bubble and lastly
the credit crunch.
4.0 Objective
1. To identify the three main factor of current global financial crisis in US
2. To determine the implication into International Financial Institution in US.
3. To identify the effect into International Financial Institution in US.
4. To determine the government responses of US towards the current global financial
crisis and International Financial Institution in US.
5.0 Literature Review
In September and October 2008, the US suffered a severe financial dislocation that saw a
number of large financial institutions collapse. Although this shock was of particular note, it is
best understood as the culmination of a credit crunch that had begun in the summer of 2006
and continued into 2007. The US housing market is seen by many as the root cause of the
financial crisis. Since the late 1990s, house prices grew rapidly in response to a number of
contributing factors including persistently low interest rates, over-generous lending and
speculation. The bursting of the housing bubble, in addition to simultaneous crashes in other
asset bubbles, triggered the credit crisis. However, it was the complex web of financial
innovations that had purportedly been employed to reduce risk which ensured that the crisis
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spread across the financial markets and into the real economy. In particular, all manner of
profit-seeking financial institutions used a complex financial process characterised by highly
leveraged borrowing, inadequate risk analysis and limited regulation to bet on one outcome a
bet which proved to be misguided when asset prices collapsed.
As Ben S. Bernanke, 1983 recognized that its effects via the money supply, the
financial crisis of 1930-33 affected the macro economy by reducing the quality of certain
financial services, primarily credit intermediation. The basic argument is to be made in two
steps. First, it must be shown that the disruption of the financial sector by the banking and debt
crises raised the real cost of intermediation between lenders and certain classes of borrowers.
Second, the link between higher intermediation costs and, the decline in aggregate output must
be established. There are many ways in which problems in credit markets might potentially
affect the macro economy. Several of these could be grouped under the heading of "effects on
aggregate supply". For example, if credit flows are dammed up, potential borrowers in the
economy may not be able to secure funds to undertake worthwhile activities or investments at
the same time, savers may have to devote their funds to inferior uses.
About the cause of current crisis Stephen said US house prices rose dramatically from
1998 until late 2005, more than doubling over this period, and far faster than average wages.
Further support for the existence of a bubble came from the ratio of house prices to renting
costs which rocketed upwards around 1999. (Stephen, 2008). Furthermore, Yale economist
Robert Schiller found that inflation-adjusted house prices had remained relatively constant over
the period 1899-1995. Pointing to the escalation in house prices and marked regional
disparities, Shiller correctly predicted the imminent collapse of what he believed was a housing
bubble. (Robert Shiller, 2005). In addition, individual-level analysis by Demyanyk and van
Hemert finds that, controlling for borrower and loan characteristics as well as macroeconomic
conditions, the credit quality of new subprime mortgages fell each year from 2001 to 2006. (
Yuliya, Hemert,2008). In other cases, there existed an incentive to voluntarily foreclose where
the value of the house and future gains associated with a stronger credit rating was smaller
than the value of the outstanding mortgage because of generous foreclosure legislation.
(Anthony,2008).
Avoiding financial instability requires several types of institutional reforms. First,
prudential regulation of the banking and financial system must be strengthened in order to
prevent these types of financial crises. (Mishkin, 2003). Second, the safety net provided by the
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domestic government and the international financial institutions set up by Bretton Woods might
need to be limited in order to reduce the moral hazard incentives for banks to take on too much
risk. (Demirguc-Kunt and Kane, 2002), Third, currency mismatches need to be limited in order
to prevent currency devaluations from destroying balance sheets. Although prudential
regulations to ensure that financial institutions match up any foreign-denominated liabilities with
foreign-denominated assets may help reduce currency risk, they do not go nearly far enough.
(Mishkin,1996). Fourth, policies to increase the openness of an economy may also help limit
the severity of financial crises in emerging market countries. The reason why openness may
affect financial fragility is that businesses in the tradable sector have balance sheets which are
less exposed to negative consequences from a devaluation of the currency when their debts
are denominated in foreign currency. Because the goods they produce are traded
internationally, they are more likely to be priced in foreign currency.
Governments are providing support and doing what so ever they can to prevent their
economical structure US government injected $800 billion in the economy to support the
structure, UK government has announced a package of $692 billion, European Union is about
to start an economic recovery plan and IMF has called for minimum financial support of $100
billion (BBC news, 2008). Also on the research part, E. Philip Davis and Dilruba Karim
suggested an “Early warning System” to cop better with such crisis; the proposed two models
“Logit” as a global early warning system and “Signal Extraction” for country specific early
warning system. DeBoer (2008) believe that such bailout programs and other supporting
packages from governments is like offering protection from a negative outcome which is more
appropriate to be called as “moral hazard” this trend could increase the possibility of future bad
upshots. Warne (2008) believes that it’s the matter of confidence of investors, as long as it is
restored, crisis will be over; but it cannot be done when we daily hear news about the
abandonment of financial institutions, it needs some financial stability. OECD Secretary
general, Gurria (2008) hopes that the effective macroeconomic policies and vital financial
reforms will turn down the heat and normal financial conditions as well as the growth rates will
return to normal in 2009. Yilmaz (2008) acknowledged that the worst part of the crisis is already
over and the markets are suffering from what can be called ‘the after shocks’. Sha Zukang
(2008) says that normalization of economic activities need “global and symentic” solutions, he
stated that current “global Economic Governance System” is derisory for the prevention of such
crisis. Governments on the other hand are doing what so ever they can to prevent their
financial institutes to fall and protect their economical structure.
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Last IMF/World Bank need to made a strong pitch for changes in the operating
framework of the multilateral financial institutions. This framework needs to puts per capita
income as the defining parameter for the assistance from the IFI’s. On that basis, US, where
per capita income is high by developing-country standards, is not eligible for special
concessionary assistance. The essence of US case is that notwithstanding our high per capita
incomes, the US faces specific vulnerabilities arriving from small size, susceptibility to natural
disasters and the impact of climate change and the very high public debt ratio. The lessons that
this crisis holds for the region that the last few months should forcefully bring to us, it should be
that, in this new global environment, deeper regional integration is absolutely critical for the
survival of all the economies. It is clearly a case of we swim together or we sink together
admittedly some faster than others. For years, we have talked closer integration. This would
seem to be the time to accelerate our efforts. We need to seriously consider and expedite
several things such as, to bring regional production structures into better alignment. Second,
the region needs to develop a policy agenda to improve its resilience in future crises. Third, we
need to quickly upgrade and harmonize regulatory and supervisory systems and put in place
mechanisms for regional regulatory coordination. Last but not least as the EU has shown, the
creation of a more cohesive regional economic and political bloc will strengthen our capacity to
bargain collectively with international financial institutions like the IMF, World Bank and WTO
and the OECD.
6.0 Discussion and Findings
6.1 Factor of current global financial crisis
United States was born from the Britain’s American colonies broke with the mother country in
1776 and were recognized as the new nation of the United States of America following the
Treaty of Paris. US has the largest and most technologically powerful econ omy in
the world, with a per capita GDP of $48,100.The crisis in 2007 in the United
States directly due to the collapse of the housing bubble in the United States in 2006, which
resulted in about October 2007, the so-called crisis of subprime mortgages. The impact of the
mortgage crisis began to manifest itself in an extremely serious since the beginning of 2008,
getting first to the U.S. financial system, and then to international, resulting in a serious liquidity
crisis, and causing, indirectly, other economic phenomena, such as a global food crisis,
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different stock collapse (like the stock in January 2008 and the global stock market crisis of
October 2008) and, overall, an economic crisis at international level.
The subprime mortgage crisis, popularly known as the “mortgage mess” or “mortgage
meltdown,” came to the public’s attention when a steep rise in home foreclosures in 2006
spiralled seemingly out of control in 2007, triggering a national financial crisis that went global
within the year. Consumer spending is down, the housing market has plummeted, foreclosure
numbers continue to rise and the stock market has been shaken. The immediate cause or
trigger of the crisis was the bursting of the United States housing bubble which peaked in
approximately 2005–2006. Already-rising default rates on "subprime" and adjustable rate
mortgages (ARM) began to increase quickly thereafter. As banks began to give out more loans
to potential home owners, housing prices began to rise. As banks began to give out more loans
to potential home owners, housing prices began to rise. 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 significant
and resulting the number of foreclosed homes also began to rise. 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 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. 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 were building, a series
of factors caused the financial system to both expand and become increasingly fragile, a
process called financialization. The crisis directly due to the collapse of the housing bubble in
the United States in 2006, which resulted in about October 2007, the so-called crisis of
subprime mortgages. The percentage of new lower-quality subprime mortgages rose from the
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historical 8% or lower range to approximately 20% from 2003–2006, with much higher ratios in
some parts of the U.S. A high percentage of these subprime mortgages, over 90% in 2006 for
example, were adjustable-rate mortgages. These two changes were part of a broader trend of
lowered lending standards and higher-risk mortgage products. After U.S. house sales prices
peaked in mid-2006 and began their steep decline forthwith, refinancing became more difficult.
As adjustable-rate mortgages began to reset at higher interest rates (causing higher monthly
payments), mortgage delinquencies soared. Securities backed with mortgages, including
subprime mortgages, widely held by financial firms, lost most of their value.
Global investors also drastically reduced purchases of mortgage-backed debt and
other securities as part of a decline in the capacity and willingness of the private financial
system to support lending. Lenders began originating large numbers of high risk mortgages
from around 2004 to 2007, and loans from those vintage years exhibited higher default rates
than loans made either before or after. 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.
Once interest rates began to rise and housing prices started to drop moderately in 2006–2007
in many parts of the U.S., refinancing became more difficult. Defaults and foreclosure activity
increased dramatically as easy initial terms expired, home prices failed to go up as anticipated,
and ARM interest rates reset higher. Falling prices also resulted in 23% of U.S. homes worth
less than the mortgage loan by September 2010, providing a financial incentive for borrowers
to enter foreclosure.
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. Some long-time critics of government claim that the roots of the crisis
can be traced directly to risky lending by government sponsored entities Fannie
Mae and Freddie Mac. Freddie Mac CEO Richard Syron agreed with Greenspan that the
United States had a housing bubble and concurred with Yale economist Robert Shiller’s 2007
warning that home prices “appeared overvalued” and that the necessary correction could “last
years with trillions of dollars of home value being lost.” Greenspan also warned of “large double
digit declines” in home values, much larger than most would expect. Subprime borrowers
typically have weakened credit histories and reduced repayment capacity. Subprime loans
have a higher risk of default than loans to prime borrowers. If a borrower is delinquent in
making timely mortgage payments to the loan servicer (a bank or other financial firm), the
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lender may take possession of the property, in a process called foreclosure. Subprime lending
was a major contributor to this increase in home ownership rates and in the overall demand for
housing, which drove prices higher.
The credit and house price explosion led to a building boom and eventually to a surplus
of unsold homes, which caused U.S. housing prices to peak and begin declining in mid-2006.
Easy credit, and a belief that house prices would continue to appreciate, had encouraged many
subprime borrowers to obtain adjustable-rate mortgages. These mortgages enticed borrowers
with a below market interest rate for some predetermined period, followed by market interest
rates for the remainder of the mortgage's term. Borrowers, who would not be able to make the
higher payments once the initial grace period ended, were planning to refinance their
mortgages after a year or two of appreciation. But refinancing became more difficult, once
house prices began to decline in many parts of the USA. Borrowers who found themselves
unable to escape higher monthly payments by refinancing began to default. This credit and
house price explosion led to a building boom and eventually to a surplus of unsold homes,
which caused U.S. housing prices to peak and begin declining in mid-2006. Easy credit, and a
belief that house prices would continue to appreciate, had encouraged many subprime
borrowers to obtain adjustable-rate mortgages.
These mortgages enticed borrowers with a below market interest rate for some
predetermined period, followed by market interest rates for the remainder of the mortgage's
term. Borrowers who would not be able to make the higher payments once the initial grace
period ended were planning to refinance their mortgages after a year or two of appreciation.
But refinancing became more difficult, once house prices began to decline in many parts of the
USA. Borrowers who found themselves unable to escape higher monthly payments by
refinancing began to default. By September 2008, average U.S. housing prices had declined by
over 20% from their mid-2006 peak. This major and unexpected decline in house prices means
that many borrowers have zero or negative equity in their homes, meaning their homes were
worth less than their mortgages. As of March 2008, an estimated 8.8 million borrowers to
10.8% of all homeowners had negative equity in their homes, a number that is believed to have
risen to 12 million by November 2008.
By September 2010, 23% of all U.S. homes were worth less than the mortgage
loan. Borrowers in this situation have an incentive to default on their mortgages as a mortgage
is typically nonrecourse debt secured against the property. Economist Stan Leibowitz argued in
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the Wall Street Journal that although only 12% of homes had negative equity, they comprised
47% of foreclosures during the second half of 2008 and concluded that the extent of equity in
the home was the key factor in foreclosure, rather than the type of loan, credit worthiness of the
borrower, or ability to pay. Increasing foreclosure rates increases the inventory of houses
offered for sale. The number of new homes sold in 2007 was 26.4% less than in the preceding
year. By January 2008, the inventory of unsold new homes was 9.8 times the December 2007
sales volume.
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. Increased foreclosure rates in 2006–2007
among U.S. homeowners led to a crisis in August 2008 for the subprime, collateralized debt
obligation (CDO), mortgage, credit, hedge fund, and foreign bank markets. In October 2007,
the U.S. Secretary of the Treasury called the bursting housing bubble "the most significant risk
to our economy. The derivatives such as mortgage-backed securities were insured by credit
default swaps or so investors thought. Hedge fund managers created a huge demand for these
supposedly risk-free securities, and therefore the mortgages that backed them.
To meet this demand for mortgages, banks and mortgage brokers offered home loans
to just about anyone. This drove up demand for housing, which homebuilders tried to meet.
Many people bought homes, not to live in them or even rent them, but just as investments to
sell as prices kept rising. When the homebuilders finally caught up with demand, housing prices
started to fall in 2006. This burst the asset bubble, and subsequently led to the subprime
mortgage crisis in 2006, the banking credit crisis in 2007 and finally the global financial crisis in
2008. Housing bubbles may occur in local or global real estate markets. In their late stages,
they are typically characterized by rapid increases in the valuations of real property until
unsustainable levels are reached relative to incomes, price-to-rent ratios, and other economic
indicators of affordability. This may be followed by decreases in home prices that result in many
owners finding themselves in a position of negative equity—a mortgage debt higher than the
value of the property. The underlying causes of the housing bubble are complex. Factors
include tax policy (exemption of housing from capital gains), historically low interest rates, lax
lending standards, failure of regulators to intervene, and speculative fever. This bubble may be
related to the stock market or dot-com bubble of the 1990s. This bubble roughly coincides with
the real estate bubbles of the United Kingdom, Hong Kong, Spain, Poland, Hungary and South
Korea.
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The impact of booming home valuations on the U.S. economy since the 2001–
2002 recession was an important factor in the recovery, because a large component of
consumer spending was fuelled by the related refinancing boom, which allowed people to both
reduce their monthly mortgage payments with lower interest rates and withdraw equity from
their homes as their value increased. On the basis of 2006 market data that were indicating a
marked decline, including lower sales, rising inventories, falling median prices and increased
foreclosure rates some economists have concluded that the correction in the U.S. housing
market began in 2006.
One possible cause of bubbles is excessive monetary liquidity in the financial system,
inducing lax or inappropriate lending standards by the banks, which asset markets are then
caused to be vulnerable to volatile hyperinflation caused by short-term, leveraged speculation.
Asset bubble is formed when the prices of specific asset classes are over-inflated due to
excess demand for the asset as an investment vehicle. Prices rise quickly over a short period
of time, and are not supported by underlying demand for the product itself. An asset bubble can
be aggravated by a supply shortage, or an over-expansion of the money supply, but most
modern asset bubbles are primarily a result of demand-pull inflation. It is a form of inflation that
is not always accurately captured in the Consumer Price Index (CPI). For that reason, asset
bubbles can be aggravated by low interest rates.
The Federal Reserve reduced interest rates to an extreme low of 1% so that after
inflation there were negative interest rates. As a result of this, mortgage rates fell to a historical
low. A significant change in the market (interest/mortgage rates) combined with an increased
supply of money is the perfect formula for an Asset Bubble. Due to these low rates, the supply
of money was high and the economy saw a huge increase in its people
borrowing. Commercial Banks had doubled the amount of real-estate loans they would
normally issue. There all-time low interest loans were extended to people with worse and worse
credit ratings. The knock-on effect of this was a huge increase in the demand for properties,
housing and other real estate assets. The bubble began to grow and the value of the real
estate assets shot up. The mortgages the banks were lending carried huge risk as many were
lent to people with poor credit histories securitization of the loans (bundling loans banks have
issued together so they can be sold, at profit, to another bank) disguised a lot of the risk. As
borrowers slowly began to default on their loans and declare bankruptcy, banks began to
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realise that they had underestimated the risk and the value of the securities began to fall and
sent the US into recession.
Between 2004 and 2006, the Federal Reserve Board raised interest rates 17 times,
increasing them from 1 percent to 5.25 percent. The Fed stopped raising rates because of
fears that an accelerating downturn in the housing market could undermine the overall
economy. Some economists, like New York University economist Nouriel Roubini, feel that the
Fed should have tightened up on the rates earlier than it did “to avoid a festering of the housing
bubble early on.” Roubini also warned that because of slumping sales and prices in August
2006, the housing sector was in “free fall” and would derail the rest of the economy, causing a
recession in 2007.The credit crunch is affecting businesses and consumers alike. On the
business end, many companies are finding it difficult to obtain large loans in order to expand
operations, or in some cases pay operating expenses. Many companies are in serious financial
trouble and layoffs are a distinct possibility. In 2008, a series of bank and insurance company
failures triggered a financial crisis that effectively halted global credit markets and required
unprecedented government intervention. Fannie and Freddie Mac (FRE) were both taken over
by the government. Lehman Brothers declared bankruptcy on September 14th after failing to
find a buyer.
Bank of America agreed to purchase Merrill Lynch (MER), and American International
Group (AIG)was saved by an $85 billion capital injection by the federal government. Shortly
after, on September 25th, J P Morgan Chase (JPM) agreed to purchase the assets
of Washington Mutual (WM) in what was the biggest bank failure in history. In fact, by
September 17, 2008, more public corporations had filed for bankruptcy in the U.S. than in all of
2007.These failures caused a crisis of confidence that made banks reluctant to lend money
amongst themselves, or for that matter, to anyone. The crisis has its roots in real estate and
the subprime lending crisis. Commercial and residential properties saw their values increase
precipitously in a real estate boom that began in the 1990s and increased uninterrupted for
nearly a decade. Increases in housing prices coincided with the investment and banking
industry lowering lending standards to market mortgages to unqualified buyers allowing them to
take out mortgages while at the same time government deregulation blended the lines between
traditional investment banks and mortgage lenders.
Real estate loans were spread throughout the financial system in the form
of CDOs and other complex derivatives in order to disperse risk, however, when home values
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failed to rise and home owners failed to keep up with their payments, banks were forced to
acknowledge huge write downs and write offs on these products. These write downs found
several institutions at the brink of insolvency with many being forced to raise capital or go
bankrupt. Credit rating agencies are now under scrutiny for having given investment-grade
ratings to MBSs based on risky subprime mortgage loans.
These high ratings enabled these MBS to be sold to investors, thereby financing the
housing boom. These ratings were believed justified because of risk reducing practices, such
as credit default insurance and equity investors willing to bear the first losses. However, there
are also indications that some involved in rating subprime-related securities knew at the time
that the rating process was faulty. Critics allege that the rating agencies suffered from conflicts
of interest, as they were paid by investment banks and other firms that organize and sell
structured securities to investors On 11 June 2008, the SEC proposed rules designed to
mitigate perceived conflicts of interest between rating agencies and issuers of structured
securities. On 3 December 2008, the SEC approved measures to strengthen oversight of credit
rating agencies, following a ten-month investigation that found "significant weaknesses in
ratings practices," including conflicts of interest. Many financial institutions, investment banks in
particular, issued large amounts of debt during 2004–2007, and invested the proceeds
in mortgage-backed securities (MBS), essentially betting that house prices would continue to
rise, and that households would continue to make their mortgage payments. Borrowing at a
lower interest rate and investing the proceeds at a higher interest rate is a form of financial
leverage.
This is analogous to an individual taking out a second mortgage on his residence to
invest in the stock market. This strategy proved profitable during the housing boom, but
resulted in large losses when house prices began to decline and mortgages began to default.
Beginning in 2007, financial institutions and individual investors holding MBS also suffered
significant losses from mortgage payment defaults and the resulting decline in the value of
MBS. In the years leading up to the crisis, the top four U.S. depository banks moved an
estimated $5.2 trillion in assets and liabilities off-balance sheet into special purpose vehicles or
other entities in the shadow banking system. This enabled them to essentially bypass existing
regulations regarding minimum capital ratios, thereby increasing leverage and profits during the
boom but increasing losses during the crisis.
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New accounting guidance will require them to put some of these assets back onto their
books during 2009, which will significantly reduce their capital ratios. One news agency
estimated this amount to be between $500 billion and $1 trillion. This effect was considered as
part of the stress tests performed by the government during 2009. Credit default swaps (CDS)
are financial instruments used as a hedge and protection for debt holders, in particular MBS
investors, from the risk of default, or by speculators to profit from default. As the net worth of
banks and other financial institutions deteriorated because of losses related to subprime
mortgages, the likelihood increased that those providing the protection would have to pay their
counterparties. This created uncertainty across the system, as investors wondered which
companies would be required to pay to cover mortgage defaults. The Financial Crisis Inquiry
Commission reported in January 2011 that CDS contributed significantly to the crisis.
Companies were able to sell protection to investors against the default of mortgage-backed
securities, helping to launch and expand the market for new, complex instruments such as
CDO's. This further fuelled the housing bubble. They also amplified the losses from the
collapse of the housing bubble by allowing multiple bets on the same securities and helped
spread these bets throughout the financial system. Companies selling protection, such as AIG,
were not required to set aside sufficient capital to cover their obligations when significant
defaults occurred. Because many CDS were not traded on exchanges, the obligations of key
financial institutions became hard to measure, creating uncertainty in the financial system
In a June 2008 speech, President of the NY Federal Reserve Bank Timothy Geithner,
who later became Secretary of the Treasury, placed 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. These entities became critical to the credit markets underpinning the financial
system, but were not subject to the same regulatory controls as depository banks. Further,
these entities were vulnerable because 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: "In early 2007, asset-backed commercial
paper conduits, in structured investment vehicles, in auction-rate preferred securities, tender
option bonds and variable rate demand notes, had a combined asset size of roughly $2.2
trillion. Assets financed overnight in trip arty repo grew to $2.5 trillion. Assets held in hedge
funds grew to roughly $1.8 trillion.
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The combined balance sheets of the then five major investment banks totaled $4
trillion. In comparison, the total assets of the top five bank holding companies in the United
States at that point were just over $6 trillion, and total assets of the entire banking system were
about $10 trillion." He stated that the "combined effect of these factors was a financial system
vulnerable to self-reinforcing asset price and credit cycles. 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, 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 artefact of excessively loose credit conditions.
6.2 Implication of US financial crisis towards international financial institution
6.2.1 Regulations and the development of markets
One of the informative studies in the evolution of US security market regulation shown that they
is no binding international financial system and global system coordinated. This condition give
the opportunity to the restrictions between state of the Bank Holding Company in the US
increased banks activities outside the country for a decades and contributed to cross border
regulatory arbitrage. US also as financial holding companies that prohibited from holding non-
financial institutions. These situations contributed to an increasingly interdependent global
economy that tries to fix with the national financial system in the absence of an effective global
framework with full support of all nations. Both national and international markets are tend to
become distorted and also lead to further global financial instability over time.
A number of studies have shown that financial globalization has been slow in slowing
rate in many parts of the world. Obviously, the recent global financial crisis has been impaired
by capital outflow from developing to developed countries and when there is uncertainty
regarding the rate of financial globalization after the global financial crisis. The state banks also
issued notes that were used locally as paper money. Moreover, bank notes of the western
states heavily discounted by the eastern states due to financial mismanagement of some banks
in the western states. In the late of 20th century it can as the emergence of the Euro and the
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European Central Bank. Although there are many numbers of challenges with the fiscal
unification of European countries, nevertheless, economic and financial integration has
reduced to increased efficiency with the emergence of a European Central Bank and a single
European currency. This type of regulation and market development in Europe is come after
disasters and the effects of new national regulatory frameworks in the absence of a globally
integrated system that led to regulatory arbitrage and ineffectiveness of the new national
rules/regulations.
6.2.2 Emergence of international institutions
One of the cases of how a crisis leads to change is the emergence of the US Federal Reserve
System in 1913. During 1837 to 1862 US are using a free banking system, followed by the
National Banking Act introduced during the Civil War. This created a system of national banks
which a system without a central bank. However, a number of banking crises started on 1873
that influence most of the traders and financial players and finally led to the emergence of a
central bank in the US in 1913.
During the Great Depression, US nations responded to the global financial crisis
almost in isolation towards each other. The World Economic Forum as nations took a
nationalistic approach that held in London on 1933 also was a failure. However, in response to
the Great Depression, a number of national rules and regulations were created in isolation from
other nations. Furthermore, some countries took a nationalistic approach that influence to a
number of global issues such as trade with increasing their tariff walls as a way of defending
their domestic. Furthermore, national governments tried to solve their banking crises in
isolation through the implementation to new national policies, rules and regulations such as the
Glass-Steagall in 1933. On 1937 the US economy entered into a double dip recession in 1937
that led the US economy to reduce unemployment and recover from almost a decade of
economic slump.
Eventually, during the Bretton Woods conference that been held during the Great
Depression, the conference and up with the establishment of the International Monetary Fund,
the World Bank and the General Agreements on Tariffs and Trade (GATT) which led to the
formation of the World Trade Organization. The emergence of these international institutions
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contributed to the promotion and better coordination of global financial stability, free trade and
development.
6.2.3 Reforms of the international financial architecture
The recent global financial crisis gives a unique opportunity for both national and international
institutions to determine a number of issues that led to the recent global recession and possibly
ways to improve international financial systems. A study by the IMF (2009a–c) of international
financial architecture stated that the recent global financial crisis has revealed important flaws
in the current global architecture. After the Asian currency crisis, the IMF referred to global
financial stability as a global public good. With increasing of financial globalization, most of the
international community has recognized the importance of global financial stability.
During the recent global financial crisis, international community took the opportunity to
seriously address a number of flaws that have existed in the international financial architecture,
as a securing way for better global financial stability. As a major global forum to deal with the
global economic and financial crisis has been a major development of the global decision-
making process in recent times G20 has been emerge. The G20 agreed with the replacement
of the Financial Stability Forum (FSF) with a new super national board called the Financial
Stability Board (FSB). This Board collaborates with other international institutions that
responsible for safeguarding the global financial stability.
However, the stability of global financial is not a national public good but rather a global
public good. This is because capital and financial products can cross national borders
immediately and sit across many multinational firms’ balance sheets in different parts of the
world. Furthermore, some of these international assets and financial products might contain
toxic components that could profane financial markets of host countries.
6.2.4 New global framework and global leadership
In the past, global financial crises contributed to changes in or the emergence of new
international institutions also the rules and principles. New global frameworks in May 2009 act
as the main method to effectively implement the policy recommendations outlined in the G20
communiqué in London. At the present time, despite a number of objectives listed for the FSB
to carry out in collaboration with national regulators, there is no guarantee that all national
regulators comply with the objectives of the FSB. There are also challenges for the FSB to
work with all the offshore canters as a way of removing regulatory arbitrage. Furthermore, there
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is significant reliance on national authorities to ensure that international institutions can fully
discharge their global responsibility.
One of the challenges on 21st century is how to deal with global financial problems that
require global solutions for global solutions that require global ownership and global leadership.
It is importance requirement of having an effective global framework to a global financial
system and the international financial architecture especially in the 21st century. In other
words, an effective global financial system and successful implementation of the international
agreements are also essential to ensure global financial stability and sustained global
economic growth. Furthermore, dynamic interaction between the national and global economy
could instantaneously move from one country to another where less effective international
institutions could negatively affect national institutions. For example the Asian currency crisis
and the recent global financial crisis have shown, less sound and effective national institutions
could also affect the effectiveness of the international financial system. Moreover they are more
information available to international institutions which could assist national regulators to see
the global implications of some of the financial risk associated with national financial products
better. However, in the presence of more international accountability, national regulators may
well be more vigilant in the discharge of their expected responsibility.
6.3 The Effect of Current Global Financial Crisis
The global financial crisis started to show its effects in the middle of 2007 and into 2008. In fact,
since August 2007, financial markets and financial institutions all over the world have been hit
by catastrophic developments with existing of problems in performance of subprime mortgages
in the US. Around the world stock markets have fallen, the Central banks have provided
support on the order of hundreds of billions, intervening not only to support the markets but
also to prevent the breakdown of individual institutions. While the large financial institutions
have collapsed or been bought out. Lastly, the governments in even the wealthiest nations
have had to come up with rescue packages to bail out their financial systems.
Many financial institutions began to be affected, particularly those with large exposures
to subprime-related structured products, leading to a series of failures of several large US
financial institutions (Bear Stearns, American Insurance Group, Lehman Brothers, Washington
Mutual, etc.). As a result, transactions in global interbank markets began to freeze due to the
perceived rise in counterparty risks, exacerbating the liquidity problem even for healthier
financial institutions. The financial institution crisis hit its peak in September and October 2008.
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Several major institutions failed, were acquired under duress, or were subject to government
takeover. These include Lehman Brothers, Merrill Lynch, Fannie Mae, Freddie Mac,
Washington Mutual, Wachovia, Citigroup, and AIG.
The US sub-prime mortgage fall down and the breakdown of connected financial sector
technologies currently working their way through world financial markets have been interpreted
as the shock both that was caused by the system and that will finally bring the Bretton Woods II
system to its end. The Bretton Woods II system requires large and sustained investment in the
US by foreign government and individuals. It seems prudent to doubt that the required faith in
the US economy and financial system can be maintained in the face of the miserable
performance of US assets and institutions. Sharp decline in the market value of US financial
assets and a general failure of most valuation models in a widespread banking panic could
indeed threaten the Bretton Woods II or any other international monetary system.
In absolute terms, the numbers involved seem large. As of April 2008, the International
Monetary Fund (IMF) was predicting aggregate losses of 945 billion dollars overall, 565 billion
dollars in US residential real-estate lending and 495 billion dollars from repercussions of the
crisis on other securities. By October 2008, the IMF had raised its loss prediction to 1.4 trillion
dollars overall, 750 billion dollars in US residential real-estate lending and 650 billion dollars
from repercussion of the crisis on other securities. Moreover, the IMF estimated that large US
and European banks lost more than $1 trillion on toxic assets and from bad loans from January
2007 to September 2009. These loses are expected to top $2.8 trillion from 2007 until 2010.
US banks losses were forecast to hit $1 trillion and European bank losses will reach $1.6
trillion. The IMF estimated that US banks were about 60% through their losses, but British and
Euro zone banks only 40%.
The global financial crisis has impacted International Development Association (IDA)
eligible countries across the world and has prompted a strong response from the international
community. The crisis commenced in industrialized countries and spread to IDA eligible
countries which were already coping with the impact of food and oil price increases. While the
crisis reached these countries with some delay, it has caused significant income and job losses
through declining external trade, remittances, and foreign direct investment flows. The slow-
down in economic activity has reduced fiscal revenues in many countries putting core spending
at risk. In IDA only countries annual core spending needs at risk are estimated to amount to
about US$11.6 billion in 2009. Moreover, the growth rate of IDA countries is expected to drop
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from 5.4 percent in 2008 to 2.2 percent in 2009. Considering population growth in IDA
countries, these numbers imply that many countries face the prospect of stagnant or even
declining per capita incomes.
The global financial crisis in US also affected to International Finance Corporate (IFC).
IFC’s capital position was impaired by the crisis, but could have supported a moderate
countercyclical response overall. In September 2008, IFC’s balance sheet contained
substantial unrealized equity gains, and write-downs were significant ($1 billion).
Nonperforming loans were relatively low, but expected to rise. IFC had also committed to
significant grants to IDA ($1.75 billion between fiscal 2008 and 2010). Nonetheless, IFC’s
estimate that it could invest 5 percent more per year in fiscal 2009 until 2011 than in 2008 was
conservative, given a rating agency assessment that IFC was well capitalized and experience
that showed gains in investing counter cyclically during a crisis. Ultimately, IFC investments fell
nearly 20 percent in the first year of the crisis well below expectation.
6.4 Government responses whether the US goverment overcome or not.
Crisis that has begun with housing bubble which the dramatic collapse of housing price due to
a low interest rates that have make the criticism occur whereby the federal kept the interest
rates too low for a long period. Because of the collapse, many banks have failed and began to
liquidate their assets. Besides that, the lending markets froze and the stock market also
decline. Government has response to the crisis by reducing the federal funds rate near to zero
levels and printing more money. United States congress also has passes a financial bill namely
Dodd-Frank Wall Street Reform and Consumer Protection Act in order to protect the customers
from the unfair treatment from the financial institution. The bill will protect the consumer by
creating the Consumer Financial Protection Bureau. Consumer will get the authority to get clear
and accurate information for the mortgage, credit card and other financial product. It is also
protect the customer from hidden fees, unfair term and so on. The bill also created the
Financial Oversight Council (FSOC) and has adopted the “Volcker Rule”. FSOC can
recommend to Federal Reserve on imposing constrain and also may force the financial
companies to divest its asstes if they pose a threat to United State financial system. (Summary
of Dodd - Frank Wall Street Reform and Consumer Protection Act, 2010).
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Federal Reserve Chairman, Dr Ben Bemanke has argued that the Federal Reserve
must evaluate what have their learned in the past experience such as in the sub-prime crisis.
He has draw four major lesson in order to protect the customer from the sub-prime mortgage
crisis if it’s happen again in the future. It is including disclosures by lenders for consumers to
make informed decisions, prohibition of a abusive practice by rules, offering of principles based
guidance together with supervisor oversight and taking less formal steps whereby working with
industry participants to establish and encourage best practices or supporting counseling and
financial education for potential borrowers.
Beside that, new law also has been adopted for the sake of the investor which is
through Securities and Exchange Commission (SEC) and Commodity Futures Trading
Commission (CFTC). There are responsible for monitoring and regulating the market for all
derivatives. While, the Office of Credit Rating Agencies have been created to provide oversight
and have authority to examine and impose fines when it’s needed. These laws are response for
a failure of agencies to assign more appropriate ratings. Beside that, for the credit crunch crisis
in order to alleviate the liquidity crunch, Federal Reserve has reduce the discount rate by half a
percentage point and lengthened the lending horizon to 30 days. Bank can borrow at the
Federal discount window but they are fears to do so because it will show or give a signal that
there are lack of creditworthiness on the interbank market. But, Fed has lowered the federal
funds rate by half a percentage point. The U.K bank Northern Rock can’t afford to finance their
operation by interbank market and accept a liquidity support from Bank of England. The crisis
has become worse starting November 2007. Fed tends to cut the federal fund rate but was not
reach the bank caught in the liquidity crunch. Then, the Term Auction Facility (TAF) has been
created by the Fed where commercial bank can bid loans against a broad set of collateral and
also for a mortgage- backed securities. Its will help to resuscitate interbank lending.
7.0 Conclusion
As a conclusion, in the late 1920s, US were experienced with the Great Depression where
stock market booms. Many countries across the world were finally hit by debt and currency
crises. It also resulted in the collapse of large financial institutions, the bailout of banks by
national governments and decline in stock markets which suffered around the world. With
higher effect in some countries than others, the Great Recession has affected the whole world
economy. Within a month, the assumptions were truth and forced western governments to
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injected larger sums of capital into their banks to prevent the bank’s collapse. After a period of
high oil prices, it’s come to persuaded central banks to keep interest rates high to against
inflation rather than to cut them in anticipation of the financial crisis spreading to the real
economy. The current economy situation of United States towards the current global financial
crisis that affected entire country in the whole world with the factor of current global financial
crisis, the implication into international financial institution, the effect into International Financial
Institution and the government give responses towards the current global financial crisis and
International Financial Institution. The global financial crisis started to show its effects in the
middle of 2007 and into 2008. Since August 2007, financial markets and financial institutions all
over the world have been hit by catastrophic developments with existing of problems in
performance of subprime mortgages in the US. Many financial institutions began to be affected,
particularly those with large exposures to subprime-related structured products, leading to a
series of failures of several large US financial institutions. The financial institution crisis hit its
peak in September and October 2008. Sharp decline in the market value of US financial assets
and a general failure of most valuation models in a widespread banking panic could indeed
threaten the Bretton Woods II or any other international monetary system. The global financial
crisis has impacted International Development Association (IDA) eligible countries across the
world and has prompted a strong response from the international community. The global
financial crisis in US also affected to International Finance Corporate (IFC). Government
reducing the federal funds rate near to zero levels and printing more money to the crisis. United
States congress also has passes a financial bill namely Dodd-Frank Wall Street Reform and
Consumer Protection Act in order to protect the customers from the unfair treatment from the
financial institution. The Consumer Financial Protection Bureau create the bill to protect
customer from hidden fees, unfair term and so on. new law also has been adopted for the sake
of the investor which is through Securities and Exchange Commission (SEC) and Commodity
Futures Trading Commission (CFTC). There are responsible for monitoring and regulating the
market for all derivatives. While, the Office of Credit Rating Agencies have been created to
provide oversight and have authority to examine and impose fines when it’s needed. for the
credit crunch crisis in order to alleviate the liquidity crunch, Federal Reserve has reduce the
discount rate by half a percentage point and lengthened the lending horizon to 30 days. Bank
can borrow at the Federal discount window but they are fears to do so because it will show or
give a signal that there are lack of creditworthiness on the interbank market. But, Fed has
lowered the federal funds rate by half a percentage point. Fed tends to cut the federal fund rate
but was not reach the bank caught in the liquidity crunch. Then, the Term Auction Facility (TAF)
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has been created by the Fed where commercial bank can bid loans against a broad set of
collateral and also for a mortgage-backed securities. Its will help to resuscitate interbank
lending.
8.0 References
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