Key factors leading to the global financial crisis of 2008/10 and its

impact on U.S. economy

Assignment work
International Business in Focus
Academic year: 2010 / 2011
Module Lecturer: Dr. Greg O´Shea
Author: Glenn Moeller
Student ID: 1021901
Due Date: Monday 13th December 2010 by 5pm
Study Program: Visiting Student Abroad (AIBS) Germany
2,991 words
 Financial crisis of 2008/10 and its impact on U.S.
economy

Table of Contents

Table of Contents................................................................................................................II
List of Figures.....................................................................................................................III
List of Tables......................................................................................................................III
List of Abbreviations…………………………………………………………………………………………………………III

1. Introduction.................................................................................................................1
2. Analysis of Key factors and its impact on U.S. economy...................................................2
2.1 U.S. Financial Sector.....................................................................................................................2
2.1.1 Reasons for selling credit claims............................................................................................4
2.1.2 Role of SPEs during the financial crisis...................................................................................5
2.1.3 Maturity transformation........................................................................................................5
2.2 Actual Development of the US financial market...........................................................................8
2.2.1 Reactions of the FED..................................................................................................................8
2.2.2 Depreciation of U.S. banks and companies...........................................................................8
2.3.1 Fear of Recession.................................................................................................................10
3. Conclusion.....................................................................................................................13
References List..................................................................................................................IV

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List of Figures
Figure 1: U.S. Foreclosure Rates 1979 until 1st Quarter 2008...................................................3
Figure 2: Process of Loan Transformation.................................................................................6
Figure 3: U.S. Interest Rates and Inflation...............................................................................11

List of Tables
Table 1: U.S. Economic Statistics.............................................................................................10

List of Abbreviations
ABCP Asset Backed Commercial Paper
ABS Asset Backed Securities
Anon. Anonymous
BaFin German Federal Financial Supervisory Authority
CDO Collateralized Dept Obligation
E.g. Example given
FAZ Frankfurter Allgemeine Zeitung
f.e. For example
FED Federal Reserve
HGB German Commercial Code
IFRS International Financial Reporting Standards
MBS Mortgage Backed Securities
n.d. no date
NINJA No Income, no Job, no assets
OECD Organisation for Economic Cooperation and Development
S&P 500 Standard & Poor`s 500
SIV Structured Investment Vehicles
SPE Structured Purpose Enterprise
U.S. United States
WISU Magazine “Das Wirtschafts Studium“

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1. Introduction
´Crises are part of the capitalist system as the sin of religion´[ CITATION Sch07 \l 1031 ]
The News is still dealing with the Financial Crisis nowadays. Nearly every day on any
TV-channel appear some messages concerning the development of the US-Economy
and there is no end in sight. The reason therefore is the real estate crisis in the
United States. Its origin had the Crisis a few years ago regarding the booming Real
Estate Market in the US. Most of the American could not afford their own home, but
– doing to lucrative offers from the banks – the temptation was too high in most of
the cases. The property market had a long-term increase in sales figures and prices
rose constantly.
After the often variable agreed interest rates raised parallel to the general held boom
and towards all expectations the real-estate prices were fallen, most of the debtors
were unable to handle their credits. Foreclosures in an unprecedented number and
Depreciations in billions were the result. The growing number of personal
bankruptcies as well as the highly losses had an enormous impact on the economy.
The Economic growth stagnates, consumption falls and recession fears rise. This
assignment explores the Financial Crisis causes from its beginning and shows the
resulting effects on the American economic sectors Banks, Companies, Consumers
and the Economic.

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2. Analysis of Key factors and its impact on U.S. economy

2.1 U.S. Financial Sector

The real-estate crisis extended onto the Banking Sector. Since 2009 a few financial
institutes, which specializes in granting of mortgage loans for debtors with low credit
ratings. In order to investigate the cause a review during the last five to eight years of
the real estate and financial market is required. During the years 2000 / 2001 the
New Economy Bubble busted on the stock market, partly influenced by the terrorist
attacks of September 11th. That was the time when the global economy began to fall
into a recession. [ CITATION Fis07 \l 1031 ]
To avoid this and to stabilize the US Situation, the former chief of Federal Reserve,
Alan Greenspan has lowered the key interest rate down to a percent. The rates were
kept low due to continuing deflation fears although the economy has recovered. This
has triggered a global credit expansion. [ CITATION Fel08 \l 1031 ] The U.S. citizens have
been lured to buy and a new form of loans was created. Without evidence of equity
they were suddenly able to borrow credits and to buy their own home. The loans
were not audited usually with lesser credit ratings assigned. These credits are called
Subprime – or Ninja Credits (No Income, no job, no assets). The credit conditions
included for the first two to three years, low fixed interest rates. For subsequent
years variable interest rates have been agreed, which were usually much higher. This
development led to high indebtedness of many households. Further, the debt
exacerbated by the fact that many U.S. citizens, driven by the projected value of their
homes, this new addition have loaned to the cars, vacation trips or more houses than
to make objects of speculation. With increasing demand for real estate also increased
their prices. This has raised the value of the property as collateral and became much
more attractive. [ CITATION Ano07 \l 1031 ]

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The banks have speculated on that housing prices in the U.S. would continue to rise.
Therefore, many banks offered a 100 percent to 110 percent home - financing. But
development took a different course. The U.S. central bank had since mid-2004 the key rate
to 4.25 percent points increased and thus the prime rate then was 5.25 percent. For many
Households this step was crucial because the loans as already mentioned above, were now
converted to variable interest rates. Many U.S. citizens were thus not repaying their loans
and consequently there were loan defaults and foreclosures. From 2000 to 2006, loans

amounting to about 1.2 trillion U.S. dollars awarded. It is estimated that about 300 up to $
400 000 000 000 of these loans are so-called "risky loans". [ CITATION Hem08 \l 1031 ]

Figure 1: U.S. Foreclosures Rate [ CITATION Mor08 \l 1031 ]

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2.1.1 Reasons for selling credit claims

To avoid these risky loans on their balance sheets, the mortgage banks have exposures this
claims to other U.S. Financial Institutions, mostly Investment banks. According to
Hemmerich, there are three main reasons why the mortgage banks have sold the loans
rather than to keep them on their own:

First, the banks want to continue growing through the new lending. To make this possible
they have to refinance, which means they have to raise new money to grant further loans.

Secondly, the banks have already since January 01st, 2007 - after the implementing the EU
Directives 2006/48/EC (Directive Bank) and 2006/49/EC (CRD) in Europe – to hold usually 8
percent of the granted loans as equity. Thus, the allocation of new Credit is limited. If the
banks sell their loans, those will be removed from its balance sheet. The banks are thus in
able to grant new loans. The U.S. had the Basel II negotiation on the minimum capital
requirements originally proposed its implementation but now postponed to 01/01/2009.

Thirdly, the banks have a way despite the sale of receivables found to make money. The sale
of credit receivables to third parties, the bank usually loses its interest margin.
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[ CITATION Hem08 \l 1031 ]

Interest margin is defined as "(...) a difference between two interests rates, particularly
between the debit and credit interest rate in bank holdings. There are Interest income and
interest expense to business volumes placed in relationship." [ CITATION Ali04 \l 1031 ] An
interest margin of one percent is already very interesting for a bank. To keep the interest
margin, nevertheless, the banks had to sell the loans to special purpose entities. These SPEs
were established for this purpose usually of the mortgage banks or an investment bank.

2.1.2 Role of SPEs during the financial crisis

A major role in this financial crisis play the SPE´s, which are called conduits or SIV (Structured
Investment Vehicles) and particular operating in maturity transformations. These companies
primarily invest in longer-term bonds with high interest rate. "As a conduit structure is called
a refinancing, which means special purpose vehicle requirements such as, for example, long-
running loans, trade receivables or externally rated securities in one or revolving behaviour
and refinancing on the issue of money market paper in an international currency".
[ CITATION Sch071 \l 1031 ]

2.1.3 Maturity transformation

The so-called transition period was the solution for the mortgage banks to retain their
interest margin. Property loans are usually long-term loans with terms of 10-15 years. These
loans subject to a high risk and therefore represent a high Interest rate paid. With the help
of the period of transformation, these purpose vehicles had been able to convert long-term
Loans into short-term Loans. A long-term loan at an interest rate, for example 6 percent, had
been turned into a short-term Credit with e.g. 4 percent interest rate by the SPV´s and then
gave it further. After a year for instance, the short-term loans were repaid and a new short-

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term credit awarded. In this way the banks, together with the SPV´s could refinance
themselves and could kept the Interest margin in the real estate loans, although these loans
were sold. They refinanced over short-term bonds of 4 percent and then received the bond
of the mortgage loan for example by 6 percent.
The long-term loans were put together in so-called demand packages. Large packages could
claim thousands of bank loans in six-digit dollar amounts from different banks including
these loans, consisted of loans which were held by Debtors with both, good and bad credit
rating. Most were such packages put together so complex, that it is difficult to recognize the
relationship between the "good" and "bad" loans to each other. The SPEs have their own
securities (bonds) created (Securitization) to finance the debt packages and they have sold
them in the capital market. Among them were ABCPs (Asset-backed commercial paper) that
a short term (e.g. few Days) and have ABS (Asset Backed Securities) which have an average
maturity (less than two years). These bonds were secured by assets (Assets e.g. mortgages).
Such ABS by mortgages assured, the MBS (Mortgage Backed Securities) are cited.
Together these structures revealed an ABS CDO (Asset Backed Securities Collateralized Debt
Obligation). These, with attractive interest rates inflated, CDOs were sold to different
investors (e.g. hedge funds, private individuals, banks, and Insurance or pension funds)
worldwide. [ CITATION Lai07 \l 1031 ]Thus this emerging financial crisis has escalated into a
global international Problem. Figure 1 shows the above-described Facts.

Figure 2: Process of Loan transformation [ CITATION Hem08 \l 1031 ]

Because of the complexity of the packages, buyers could not claim the different credit
ratings, which were included in the packages. Consequently, they gave a great importance to
the opinion of rating agencies set, which valued mostly bonds as AAA-rated. Crucial for the
good rating by the rating agencies was that the Banks as owners of special purpose entities,
also called sponsors, appropriate liquidity guarantees promised. This, as the banks could
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take the risks out of their balance sheet, because the purpose vehicles made outside the
balance sheet and thus out of the banking supervision. The assets of the banks and special
purpose vehicles were strictly separated, e.g. that the SPEs were protected from the
financial problems of the sponsors. Thus, banks were required by the special purpose
entities to purchase commercial paper issued when the investors would not buy them. This
exact scenario has arrived: The owners of the commercial paper were suspicious and refused
to follow-on investments. [ CITATION Fra07 \l 1031 ]
Thus, the purpose vehicles ran into difficulties and the Owners (banks) had, as contractually
agreed, to pay for them. The affected banks were in such a situation they could not prepare
for and the risks have been underestimated. The liquidity guarantees grant may have been
the sponsors forced new loans record. The lending institutions were therefore sceptical been
refused and demanded money market loans or high interest rates. It came to a breach of
confidence among banks. This was on the lack of transparency and lack of Bank regulation in
the banking system.
The purpose entities are not consolidated in the balance sheets and thus are those of the
Bank risk-taking is not visible from outside the type and scope.
Consequently, other banks were suspicious and feared that granted loans would not been
repaid. According to the IFRS (International Financial Reporting Standard) recently stricter
consolidation rules are for example according to German Commercial Code (HGB), the
special purpose companies still do not balance sheet to consolidate. Thus, it was easy for
banks dealing with no major problems to manage the risks and to disguise it in order to
provide cheaper money. [ CITATION Sch071 \l 1031 ]

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2.2 Actual Development of the US financial market

2.2.1 Reactions of the FED
Until summer 2006, peak prices in the property market achieved. Then the housing bubble
busted and there was oversupply to homes in the U.S. housing market. Real estate prices
began to fall. The properties as collateral for mortgage loans therefore lost its value. The ex-
chief of the Federal Reserve, Alan Greenspan assumes that house prices will fall even
further. Depending on how the property prices continue to develop, it impacts the global
economic fate. To prevent the risk of recession and the spread of the crisis, the U.S. Federal
Reserve lowered key interest rates again. To keep the banking system liquid, the central
bank pumped at short notice cash injections of about 24 billion U.S. dollars into the financial
market.
In addition, it was decided by the central bank that no longer only commercial banks but also
investment banks in Fed can refinance. [ CITATION Ano071 \l 1031 ]

2.2.2 Depreciation of U.S. banks and companies

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The financial crisis has affected several banks serious, since at the banks concerned there
have been large losses. Worldwide the banks have now about 130 billion dollars of so-called
"bad" Loans written off. In the 3rd and 4 Quarter of last year there were at the Citigroup
write-downs of over $ 24,600,000,000, at Merrill Lynch in the same period there were 23.6
billion U.S. dollars and the Bank of America had to write off 5.3 billion U.S. dollars. At UBS
Depreciation amounted to 14.4 billion U.S. dollars. An end still does not seem to be in sight.
The rating agency Standard & Poor's still expected late last year with up to 265 billion U.S.
dollars depreciation overall. [ CITATION Ano08 \l 1031 ] The tendency of the related Estimates
increases. The German Federal Financial Supervisory Authority (BaFin) estimates in the worst
case, now with a Sum of $ 600 billion write-downs of American Banks. In early April 2008,
already 295 Billion dollars losses has been admitted officially from U.S. banks, of which about
10 Percent belong to German institutes. [ CITATION Ano081 \l 1031 ] "The amount of
depreciation on so-called sub-prime securities, so products based on inferior American
mortgage debts based shall do according to how far house prices fall in the U.S."
[ CITATION Sch08 \l 1031 ], said Jochen Sanio, President of the BaFin in an interview in April in

German newspaper "Time".

2.3 Impact on U.S. Businesses
The global crisis is already showing its impact on the various Industries and is significant for
individual companies. These effects are visible in the results of the large Corporations.
According to expert forecasts, the profits of the 500 largest U.S. companies expected to
decline significantly. Declining Earnings forecasts exists as well for European companies.
Particularly strong impact shows the crisis in the financial sector. Expectations go up until 60
percent decline in profits. In addition to the banks suffer particularly cyclical consumer goods
companies, as the private consumption Households indicates a reticent behaviour. As the
calculations of the Financial Services “Thomson Financial” shows, the gains in U.S. consumer
goods are going too shrunk by 10 percent. [ CITATION Ebe08 \l 1031 ] But the other Industries
are also struggling with bad quarterly figures. The aluminium producer Alcoa had in the 1 st
Quarter compared to the prior year quarter report a profit decline of 52 percent. CEO Alain
Belda claimed that - in addition to the effects of the credit crisis – the profit slump may
attribute to increases in energy and commodity prices and the weak dollar. [ CITATION
Ano082 \l 1031 ] Taken heavy from the consequences of the financial crisis is also the world's

largest U.S. conglomerate General Electric. CEO Jeff Immelt acknowledged recently that the
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figures for the year 2008 will be disappointing. Shrinking profits had been reported in the 1st
Quarter, which impacts the annual forecast negatively. [ CITATION Ano083 \l 1031 ]
The biggest fear is that the credit crisis already reached the real economy, and slows down
many businesses. The first quarter is the third in a row in which profits of the S & P 500
(Standard & Poor's 500)-listed companies decline. Analysts give the financial industry's fault.
In technology and supply industry, as well as energy, healthcare and telecom industries
further increase in profits are forecasted. [ CITATION Lan08 \l 1031 ] Banks has become more
cautious with lending loans. Thereby industrial investments return accordingly. This
expected to have a negatively affect on the economic growth in the coming Quarters.

2.3.1 Fear of Recession

The economy of the strongest economic power, which generates about one-fifth of the
annual world income, has since the financial crisis in mid-last year, repeatedly experienced
burglaries. In 2007, the Economy weakened compared to previous years, but still increased
for the whole year by 2.2 percent. However, it is the weakest growth since the terrorist
attacks 2001.

2007 2006 2005

GDP nominal (Bill. USD) 13,843 13,195 12,434
GDP real growth 2,2 % + 2.9 % + 3.1 %
Unemployment rate 4,6 % 4.6 % 5.1 %
Consumer Prices 4.1 % + 2.5 % + 3.4 %
Table 1: U.S. Economic Statistics [ CITATION USD08 \l 1031 ]

There are already signs now that the U.S. economy for the full year 2008 stands still
significantly worse. In early March, the organization of the rich countries - OECD – has
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published the forecast that it is in the first half of 2008 come to "zero growth" and many
economists mentioned since the beginning of the year again recession fears. If there would
be a shrinking U.S. economy, it would have serious consequences for the entire world
economy because U.S. is the largest Import land. [ CITATION Bro08 \l 1031 ] America consumes
more than it produces.
The real estate crisis impacts the confidence of the people, the labour
market and bank lending still significant, with the Result, households cut back their
consumption and planned postpone purchases. Also, business investment for machinery and
equipment continue to fall. For the further development however, private consumption is
mainly critical. It accounts for nearly 70 percent of gross domestic product of the USA. Three
Factors affecting consumer spending currently: the declining House prices to fall and in some
cases falling share prices of assets, rising unemployment, reduced income growth and the
rising energy prices cause real income losses. If the economy weakens further, losses on
loans and corporate bonds are going to increase.
To counteract the risk of recession, the U.S. Federal Reserve, under headed by Ben
Bernanke, since the crisis began August 2007 to present, lowered its key rate seven times in
a row, a total of 3.25 Percentage points to 2 percent lower, pumping liquidity into the
market, [ CITATION Ano084 \l 1031 ] because the Fed is required by law for monetary stability
and to attend the high employment. In September last Year, it lowered - for the first time
since June 2006 - interest rates by 50 basis points from 5.25 to 4.75 percent, followed by 25
basis points to 4.5 percent in late October 2007 and mid-December to 4.25 Percent.
Further rate cuts became necessary through the bleak economic outlook in January 2008.
The Fed lowered the interest rates within a week by 75 basis points from 4.25 to 3.5 percent
and a short time later by another 50 basis points to 3.0 percent. [ CITATION Ano085 \l 1031 ]
The recent reductions to date in mid-March at 75 basis- points in late April and again by 25
points to 2.0 percent now.
A further cut in interest rates, as after the bursting of the high-tech bubble a few years ago
to 1 percent - even if the economy should continue to shrink – is rather unlikely.

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Figure 3: U.S. Interest Rates and Inflation [ CITATION Fed08 \l 1031 ]

If it lowers its key rate, commercial banks also requires lower Interest. This stimulates
consumption and investment, animated stock prices and devalues the currency. The
economy is stimulated. Interest Rate Cuts however, must be undertaken with caution,
otherwise rising inflation due to cheap money, as money devalues and provoke failures at
the financial markets. [ CITATION Sch081 \l 1031 ] With each interest rate cut the Fed increases
the risk of inflation.
As a further measure against a potential recession, Democrats and Republicans in Congress
in January 2008 agreed on a comprehensive economic stimulus package of over $ 150 billion
that corresponds about 1 percent of U.S. gross domestic product. The Package provides for
more than 117 million U.S. families from tax refunds each of at least 300 dollars and
investment incentives before. In addition to in distress rated trends homeowners’
recapitalisations be facilitated. [ CITATION Sch082 \l 1031 ] If the U.S. households on the
economic-emergency program and ignited the resulting tax refunds could spend, the U.S.
also bring back new life into the world economy.

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3. Conclusion
This Essay has shown that the housing crisis has signed off for years. The market was slow
out of control advised: Real estate financier forgave loans without checking their customer’s
credit ratings, rating agencies awarded frivolous labels of quality and banks managed billion
risks outside its balance sheet.
The greed for profit and power let them miss it to initiate countermeasures, which would
have been likely to prevent the development of a global financial crisis. After the self-healing
Market had failed, only temporary, quick intervention of the Central Banks could hold a
"financial meltdown" away.
This can flare up again controversy whether a State intervention and the use of taxpayers'
money in crisis situations should be justified.
Despite all this billion Depreciation from the banks, massive foreclosures from homes and
the massive job cuts could not be prevented.
The crisis has shaken investor’s confidence strong. To recover it, the need to produce

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substantial improvements in the entire financial system is one of the most important issues.
Consensus exists at the points of transparency, risk management and banking regulation.
The self-imposed code of conduct of the banks is a first step in the right direction. For this
has success, consistent and constant review of compliance is inevitable. For the future, the
financial world should know that an early prevention of such a crisis includes much lower
losses, than to eliminate a country in ruins after the event.
This requires an early recognition of dangers ahead by experts so that appropriate measures
can be taken.
It remains to be seen how the financial crisis is going to develop furthermore. Currently it is
not yet clear in which direction it moves. Both extremes appear even possible: The
escalation of the crisis, as well as their soon end.

"You must hold up a mirror to the world of finance. It has

disgraced powerful. And a clearly audible mea culpa miss
I still. Only a capitalism that is ready to be the responsibility
to bind a future. " [ CITATION Vor08 \l 1031 ]

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