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The 2007-2008 Debt

Crises
The Worst Economic Crisis that Spread
like epidemic.
Ahmed Faizan

Ahmed Faizan Student Id: 14447

The 2007-2008 Debt Crises

Table of Contents
Core Report

Introduction................................................................................................................ 3
Part I: How We Got Here............................................................................................. 5
Part II: The Bubble.................................................................................................... 12
The origins of the housing bubble.........................................................................13
The second phase of the housing bubble..............................................................13
The access of housing bubble...............................................................................14
The Financial Contributor of the Bubble................................................................16
Part III: The Crisis...................................................................................................... 21
Declines Begin....................................................................................................... 21
The Landslide Begins- Time Line...........................................................................22
The Way Forward................................................................................................... 24
Effect on Pakistan.................................................................................................. 26
Supplementary Reading:
Synopsis
Part I: How We Got Here
Part II: The Bubble
Part III: The Crisis
Important Terminologies Discussed
Bubble Economy:
Sub-prime mortgages:
Foreclosure:
Collateralized Debt Obligation (CDO):
How It Works/Example:
Hedge funds:
Mortgage-Backed Securities:
Adjustable-Rate Mortgage ARM:
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Credit Default Swap (CDS):
.

Introduction
The financial crisis of 20072008, also known as the Global
Financial Crisis and 2008 financial crisis, is considered by
many economists to be the worst financial crisis since the Great
Depression of the 1930s. It resulted in the threat of total collapse
of large financial institutions, the bailout of banks by national
governments, and downturns in stock markets around the world.
In many areas, the housing market also suffered, resulting in
evictions, foreclosures and prolonged unemployment. The crisis
played a significant role in the failure of key businesses, declines
in consumer wealth estimated in trillions of US dollars, and a
downturn in economic activity leading to the 20082012 global
recession and contributing to the European sovereign-debt crisis.
The bursting of the U.S. housing bubble, which peaked in 2006,
caused the values of securities tied to U.S. real estate pricing to
plummet, damaging financial institutions globally. The financial
crisis was triggered by a complex interplay of policies that
encouraged home ownership, providing easier access to loans for
subprime borrowers, overvaluation of bundled sub-prime
mortgages based on the theory that housing prices would
continue to escalate, questionable trading practices on behalf of
both buyers and sellers, compensation structures that prioritize
short-term deal flow over long-term value creation, and a lack of
adequate capital holdings from banks and insurance companies to
back the financial commitments they were making.
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, and reached new lows in
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2012. On December 30, 2008 the Case-Shiller home price index
reported its largest price drop in its history. The credit crisis
resulting from the bursting of the housing bubble is according
to "general consensus" "the primary cause" of the 20072009
recessions in the United States.
Increased foreclosure rates in 20062007 among U.S.
homeowners led to a crisis in August 2008 for the subprime, Alt-A,
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 collapse of the U.S. Housing Bubble had a direct impact not
only on home valuations, but the nation's mortgage markets,
home builders, real estate, home supply retail outlets, Wall Street
hedge funds held by large institutional investors, and foreign
banks, increasing the risk of a nationwide recession.
The immediate cause or trigger of the crisis was the bursting of
the United States housing bubble which peaked in approximately
20052006. 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.
Easy availability of credit in the US, fueled by large inflows of
foreign funds after the Russian debt crisis and Asian financial
crisis of the 19971998 period, led to a housing construction
boom and facilitated debt-financed consumer spending. Lax
lending standards and rising real estate prices also contributed to
the Real estate bubble. Loans of various types (e.g., mortgage,
credit card, and auto) were easy to obtain and consumers
assumed an unprecedented debt load.
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
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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.

Part I: How We Got


Here
The global financial crises of 2008 cost tens of millions of people
their savings, their jobs and their homes.
In September 2008, the bankruptcy of the U.S. investment Bank
Lehman Brothers and the collapse of the worlds largest
insurance company AIG triggered a global financial crises; the
result was a global recession which cost the world tens of trillions
of dollars and rendered 30million people unemployed.
After the Great Depression, the United States had 40 years of
Economic Growth without a single financial crises; the financial
sector was tightly regulated. In the 1980s the financial industry
exploded the investment banks went public (prior to that they
were private owned entities) giving them huge amounts of stock
holder money.
The Reagan Administration, supported by
economist and financial lobbyist started a 30-year period of
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financial deregulation. In 1982, the Reagan administration
deregulated savings and loan companies allowing them to make
risky investments with their depositors money; by the end of the
decade hundreds of savings and loan companies had failed and
the crises that followed cost tax payers 124billion of dollars and
cost many people their life savings.
U.S. Government policy from the 1980s onward had emphasized
deregulation to support business, which resulted in less oversight
of activities and less expos of information about new activities
undertaken by banks and other growing financial institutions.
Thus, policymakers did not instantly know the increasingly key
role played by financial institutions such as investment banks and
hedge funds, also known as the shadow banking system. Some
experts believe these institutions had become as important as
commercial (depository) banks in providing credit to the U.S.
economy, but they were not subject to the same regulations.
By the late 1990s the financial sector had consolidated into few
gigantic firms, each of them so large that their failure could
threaten the entire system. In 1998, Citicorp and Travelers
merged to form Citigroup, the largest financial services company
in the world. The merger violated the Glass-Steagall Act, a law
passed after the Great Depression which prevented banks with
consumer deposits from engaging in risky investment banking
activities- in other words it was illegal to acquire Travellers. In
1999, the U.S Congress passed the Gramm-Leach-Bliley-Act it
overturned Glass- Stegall and cleared the way for future mergers.
The next Crises came at the end of the 1990s, the investment
banks fueled a massive bubble in Internet Stocks, which was
followed by a crash in 2001 that caused 5trillion dollars in
investment losses.
Beginning in the 1990s deregulation and advances in technology
lead to an explosion of complex financial products called
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derivates. Economist and bankers claimed they made markets
safer, but instead they made markets unstable. Using derivatives,
bankers could gamble on virtually anything; they could bet on the
rise or fall of oil prices, the bankruptcy of a company etc-by the
late 1990s derivates were a 50 trillion dollar unregulated market.
In December 2000, the U.S congress passed the Commodity
Future Modernization Act; it banned the regulation of
derivatives and the use of derivatives exploded dramatically after
2000. The U.S financial sector had by then become vastly
profitable, concentrated and more powerful than ever before.
Dominating this industry were 5 investment banks Goldman
Sachs, Morgan Stanley, Lehman Brothers, Merrill Lynch and Bears
Stearns; two Financial conglomerates CitiGroup and JP Morgan;
three securities- insurance companies AIG, MBIA, AMBAC and
three rating agencies Moodys, Standard & Poors and Fitch.
Linking all of them together was the Securitization Food Chain:

This Securitization Food Chain was a new system which connected


trillions of dollars in mortgages and other loans with investors all
over the world.
In the old system before securitization, when the homeowner paid
their mortgage every month the money went to their local lender
and since mortgages took decades to repay lenders were careful.

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In the new system, lenders sold the mortgages to investment


banks

The investment banks combined thousands of mortgages and


other loans- including car loans, student loans and credit card
debt to create complex derivatives, called Collateralized Debt
Obligations (CDOs).

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The investment banks then sold the CDOs to investors.

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Now when homeowners paid their mortgages, the money went to
investors
all
over
the
world.

The investment banks paid rating agencies to evaluate the CDOs,


and many of them were given AAA rating which is the highest
possible investment grade.

This made CDOs popular with retirement funds, which could only
purchase high level securities.
This system in essence was a ticking time bomb as lenders didnt
care anymore whether a borrower could repay the loan, so they
started making riskier loans. The investment banks didnt care
either the more CDOs they sold the higher their profits. The
rating agencies which were paid by the investment banks had no
liability if their ratings of CDOs were proved wrong.

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Between the years 2000 and 2003, the number of mortgage loans
made each year had nearly quadrupled.

While in the early 2000s there was a huge increase in the riskiest
loans, called subprime loans.

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But when thousands of subprime loans were combined to form


CDOs, many of them still received AAA ratings.

The investment banks preferred subprime loans because they


carried higher interest rates, this in turn lead to a massive
increase in Predatory lending. Borrowers were needlessly placed
in expensive subprime loans, and many loans were given to
people who could not repay them.
Suddenly hundreds of billions of dollars a year were
flowing through the securitization chain and since anyone
could get a mortgage, home purchases and housing prices
skyrocketed the result was inevitably the biggest financial
bubble in history.

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Part II: The Bubble


The origins of the housing bubble
The housing bubble in the United States grew up alongside the
stock bubble in the mid-90s. The logic of the growth of the bubble
is very simple. People who had increased their wealth
substantially with the extraordinary run-up of stock prices were
spending based on this increased wealth.
The stock wealth induced consumption boom also led people to
buy bigger and/or better homes, since they sought to spend some
of their new stock wealth on housing. This increase in demand
had the effect of triggering a housing bubble because in the shortrun the supply of housing is relatively fixed. Therefore an increase
in demand leads first to an increase in price. Increased prices got
incorporated into expectations. The expectation that prices would
continue to rise led homebuyers to pay far more than the actual
price of real state.
The fact that rents had risen by less than 10 percent in real terms
should have provided more evidence to support the view that the
country was experiencing a housing bubble. If there were
fundamental factors driving the run-up in house sale prices they
should be having a comparable effect on rents. However, the
increase in rents was far more modest and was trailing off already
by 2002.

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The second phase of the housing bubble


The run-up in prices in both the ownership and rental markets was
having a significant supply-side effect, as housing starts rose
substantially from the mid-90s through the late 90s. By 2002,
housing starts were almost 25 percent above the average rate
over the three years immediately preceding the start of the
bubble. The loss of faith in the stock market caused millions of
people to turn to investments in housing as a safe alternative.
Further, the economy was very slow in recovering from the 2001
recession. The weakness of the recovery led the Federal Reserve
Board to continue to cut interest rates, eventually pushing the
federal funds rates near to 1.0 percent in 2003. Mortgage interest
rates followed the federal funds rate down.
These extraordinarily low interest rates accelerated further house
prices. Housing rates starts eventually peaking at 2,070,000 in
2005, more than 50 percent above the rate in the pre-bubble
years. The run-up in house prices also had the predictable effect
on savings and consumption. Consumption boomed because the
savings rate falling to less than 1.0 percent (2005-07).
The voluntary foreclosures take place when people realize that
they owe more than the value of their home, and decide that
paying off their mortgage is in effect a bad deal. In cases where a
home is valued far lower than the amount of the outstanding
mortgage, homeowners may be too able to effectively pocket
hundreds of thousands of dollars by simply walking away from
their mortgage. There is no way that an economy can see a loss
of wealth of this magnitude without experiencing very serious
financial stress.

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The access of housing bubble


As the house prices grew further out of line with fundamentals,
the financial industry adopted more sophisticated financial
innovations to support its growth. A key part of the story was the
growth of non-standard mortgages. The vast majority of
mortgages had always been fixed rate mortgages. However,
adjustable rate mortgages became a growing share of mortgages
issued during the boom, peaking at close to 35 percent in 200406. Not only did these mortgages not provide the security of fixed
rate mortgages, they were often issued with below market teaser
rates that would reset to higher levels after two years, even if
interest rates did not rise.
The subprime market exploded during this period, rising from less
than 9 percent of the market in 2002 to 25 percent of the market
by 2005. In addition, to this explosion in subprime loans there was
also a boom in the intermediate Alt-A mortgage category. These
were loans given to homebuyers who either had a mixed credit
record (better than subprime, but not quite prime) or who
provided incomplete documentation of income and assets.
The Alt-A loans were in many cases of more questionable quality
than the subprime loans. Many (perhaps most) of these loans
were for the purchase of investment properties. The Alt-Aloans
were even more likely to have very high loan to value ratios, with
many buyers borrowing the full value of the purchase price, or in
some cases even a few percentage points more than the
purchase price.
The subprime and Alt-A categories together comprised more than
40 percent of the loans issued at the peak of the bubble. The
explosion of loans in these higher risk categories should have
been sufficient to signal regulators, as well as investors, that
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there was a serious problem in the housing market. Just to take
the case of the subprime market; it is absurd to think that the
number of credit worthy people in the subprime category had
more than doubled from 2002 to 2004, even as the labor market
remained weak and wages lagged behind inflation. The increase
in subprime lending over these years, by itself, was an
unmistakable warning sign of the problems in housing market.
Unfortunately, instead of taking this warning, political leaders and
most experts of housing celebrated the record rates of home
ownership.
Increased foreclosure rates in 20062007 among U.S.
homeowners led to a crisis in August 2008 for the subprime, Alt-A,
collateralized debt obligation (CDO), mortgage, credit, hedge
fund, and foreign bank markets.
The subprime lending alone increased from 30 billion a year in
funding to over 600 billion a year, in 10 years with Countrywide
Financial, the largest subprime lender, issued 97 billion dollars
worth of loans (It made over 11 billion dollars in profits as a
result).
On Wall Street, this housing and credit bubble was
leading, to hundreds of billions of dollars of profits. The
real issue however was it wasn't real profits, it wasn't real
income; it was just money that was being created by the
system, and if there were to be a default it would all be
wiped out.

The Financial Contributor of the Bubble


There was another ticking time bomb in the financial system
besides the housing sector.
AIG, the world's largest insurance company, was selling huge
quantities of derivatives, called credit default swaps. For investors
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who owned CDOs, credit default swaps worked like an insurance
policy. An investor who purchased a credit default swap paid AIG a
quarterly premium.

If the CDO went bad, AIG promised to pay the investor for their
losses.

But unlike regular insurance, speculators could also buy credit


default swaps from AIG in order to bet against CDOs they didn't
own.

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Since credit default swaps were unregulated, AIG didn't have to


put aside any money to cover potential losses. But if the CDOs
later went bad, AIG would be run massively heavy losses as it
would have to pay both speculators and investors.

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AIG's Financial Products Division in London issued 500 billion
dollars worth of credit default swaps during the bubble, many of
them for CDOs backed by subprime mortgages
As per the Goldman Sachs issue of securities on subprime loans
showed borrowers had borrowed, on average, 99.3 percent of the
price of the house which essentially meant they have no money in
the house; if anything were to go wrong, the borrowers were likely
to walk away from the mortgage and the loan would end up being
defaulted. In essence Goldman Sachs sold at least 3.1 billion
dollars' worth of these toxic CDOs in the first half of 2006; while
two thirds of this loan were rated AAA, which meant they were
rated as safe as government securities which was obviously
misleading.

By late 2006, Goldman had taken things a step further. It didn't


just sell toxic CDOs; it started actively betting against them by
purchasing credit default swaps from AIG.

Goldman could bet against CDOs it didn't own, and get paid when
the CDOs failed.
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Goldman Sachs bought at least 22 billion dollars of credit default


swaps from AIG. It was so much that Goldman realized that AIG
itself might go bankrupt AIG's potential collapse.
In 2007, Goldman went even further. They started selling CDOs
specifically designed so that the more money their customers
lost, the more money Goldman Sachs made.
Morgan Stanley was also selling mortgage securities that it was
betting against, and it's now being sued by the government
employees retirement fund of the Virgin Islands for fraud. The
lawsuit alleges that Morgan Stanley knew that the CDOs were
junk. Although they were rated AAA, Morgan Stanley was betting
they would fail. A year later, Morgan Stanley had made hundreds
of millions of dollars, while the investors had lost almost all of
their money.
The Hedge Funds Tricadia & Magnetar made billions betting
against CDOs they had designed with Merrill Lynch, J.P. Morgan
and Lehman Brothers. The CDOs were to CUSTOMERS AS "SAFE"
INVESTMENTS by rating agencies Moody's and Standard and
Poor's who rated these very same CDOs as AAA which essentially
meant they were as safe as government securities.

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Part III: The Crisis


Declines

Begin

there were early signs of distress: by 2004, U.S. homeownership


had peaked at 70%; no one was interested in buying or eating
more candy. Then, during the last quarter of 2005, home prices
started to fall, which led to a 40% decline in the U.S. Home
Construction Index during 2006. Not only were new homes being
affected, but many subprime borrowers now could not withstand
the higher interest rates and they started defaulting on their
loans.
This caused 2007 to start with bad news from multiple sources.
Every month, one subprime lender or another was filing for
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bankruptcy. During February and March 2007, more than 25
subprime lenders filed for bankruptcy, which was enough to start
the tide. In April, well-known New Century Financial also filed for
bankruptcy.

Investments and the Public


Problems in the subprime market began hitting the news, raising
more
people's
curiosity.
According to 2007 news reports, financial firms and hedge funds
owned more than $1 trillion in securities backed by these nowfailing subprime mortgages - enough to start a global financial
tsunami if more subprime borrowers started defaulting.
By June, Bear Stearns stopped redemptions in two of its hedge
funds and Merrill Lynch seized $800 million in assets from two
Bear Stearns hedge funds. But even this large move was only a
small affair in comparison to what was to happen in the months
ahead.

The Landslide Begins- Time Line


Chronological order:
February 2007- The Federal Home Loan Mortgage Corporation
(Freddie Mac) announces that it will no longer buy the most risky
subprime mortgages and mortgage-related securities.
April 2007 -New Century Financial Corporation, a leading
subprime mortgage lender, files for Chapter 11 bankruptcy
protection.
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June 2007 - Standard and Poors and Moodys Investor Services


downgrade over 100 bonds backed by second-lien subprime
mortgages. Standard and Poors places 612 securities backed by
subprime residential mortgages on a credit watch. Countrywide
Financial Corporation warns of difficult conditions. Bear Stearns
liquidates two hedge funds that invested in various types of
mortgage-backed securities.
August 2007- American Home Mortgage Investment Corporation
files for Chapter 11 bankruptcy protection. BNP Paribas, Frances
largest bank, halts redemptions on three investment funds.
September 2007- The Chancellor of the Exchequer authorizes
the Bank of England to provide liquidity support for Northern
Rock, the United Kingdoms fifth-largest mortgage lender.
January 2008- Bank of America announces that it will purchase
Countrywide Financial in an all-stock transaction worth
approximately $4 billion.
February 2008- Northern Rock is taken into state ownership by
the Treasury of the United Kingdom.
March 2008 - The Federal Reserve Bank of New York announces
that it will provide term financing to facilitate JPMorgan Chase &
Co.s acquisition of The Bear Stearns Companies Inc. A limited
liability company (Maiden Lane) is formed to control $30 billion of
Bear Stearns assets that are pledged as security for $29 billion in
term financing from the New York Fed at its primary credit rate.
JPMorgan Chase will assume the first $1 billion of any losses on
the portfolio.

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September 2008 - Bank of America announces its intent to
purchase Merrill Lynch & Co. for $50 billion. Lehman Brothers
Holdings Incorporated files for Chapter 11 bankruptcy protection.
On September 16, 2008, AIG suffered a liquidity crisis following
the downgrade of its credit rating. Industry practice permits firms
with the highest credit ratings to enter swaps without depositing
collateral with their trading counter-parties. When its credit rating
was downgraded, the company was required to post additional
collateral with its trading counter-parties, and this led to an AIG
liquidity crisis. AIG's London unit sold credit protection in the form
of credit default swaps (CDSs) on collateralized debt obligations
(CDOs) that had by that time declined in value.[26] The United
States Federal Reserve Bank announced the creation of a secured
credit facility of up to US$85 billion, to prevent the company's
collapse by enabling AIG to meet its obligations to deliver
additional collateral to its credit default swap trading partners.
AIG's share prices had fallen over 95% to just $1.25 by September
16, 2008, from a 52-week high of $70.13.[citation needed] The
company reported over $13.2 billion in losses in the first six
months of the year. The AIG Financial Products division headed by
Joseph Cassano, in London, had entered into credit default swaps
to insure $441 billion worth of securities originally rated AAA. Of
those securities, $57.8 billion were structured debt securities
backed by subprime loans.[34] CNN named Cassano as one of the
"Ten Most Wanted: Culprits" of the 2008 financial collapse in the
United States.
Till 14 December 2012 the crisis engulfed 493 banks in the US
alone, including the likes of Lehman Brothers Holdings, American
International Group and Bear Stearns. (US Federal Deposit
Insurance Corporation).

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The Way Forward


In John Maynard Keynes Keynes' view, when main pillars of the
economy are failing - consumer spending, investment and net
exports - the only pillar that is left to support the economy is the
government.
Keynes supported government intervention during times of
economic turmoil. Among the theories he presented in "General
Theory" was that economies are chronically unstable and that full
employment is only possible with a boost from government policy
and public investment. Keynes believed that it was up to the
government to bridge the gap between the economy's potential
and its actual output during a financial crisis, even if that meant
taking on debt.
Hence following the Keynes economic model, to keep the
economy from faltering any further the governments needed to
take action and thats precisely what happened next.
The U.S. Federal Reserve and central banks around the world took
steps to expand money supplies to avoid the risk of a deflationary
spiral, in which lower wages and higher unemployment lead to a
self-reinforcing decline in global consumption.
In addition, governments had enacted large fiscal stimulus
packages, by borrowing and spending to offset the reduction in
private sector demand caused by the crisis. The U.S. executed
two stimulus packages, totaling nearly $1 trillion during 2008 and
2009. The U.S. Federal Reserve's new and expanded liquidity
facilities were intended to enable the central bank to fulfill its
traditional lender-of-last-resort role during the crisis while
mitigating stigma, broadening the set of institutions with access
to liquidity, and increasing the flexibility with which institutions
could tap such liquidity.
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This credit freeze brought the global financial system to the brink
of collapse. The response of the Federal Reserve, the European
Central Bank, and other central banks was immediate and
dramatic. During the last quarter of 2008, these central banks
purchased US$2.5 trillion of government debt and troubled
private assets from banks. This was the largest liquidity injection
into the credit market, and the largest monetary policy action, in
world history. The governments of European nations and the USA
also raised the capital of their national banking systems by
$1.5 trillion, by purchasing newly issued preferred stock in their
major banks.

Effect on economic situation in Pakistan


Pakistans deteriorating macroeconomic conditions after the
Global Financial Crisis had resulted in sharp downfall in GDP
growth rate. Real GDP growth rate declined significantly in 2008
as it reached to 1.6 % and in 2009 it rose slightly to 3.4 %.
Unfortunately,
Pakistan
was
already
suffering
from
macroeconomic instability before the Financial Crisis due to hike
in oil prices and depleting foreign exchange reserves. Financial
Crisis widened trade gap. Increase in budget and current account
deficits and soaring inflation brought further problems for
Pakistans economy.
Under IMF agreement Pakistan has to adopt tight fiscal and
monetary policies. IMF program is directed towards restoring
macroeconomic stability in Pakistan. State Bank of Pakistan has
increased discount rates to curb inflation but it has also hampered
economic growth. Private investment is restricted due to increase
in discount rates. Public finances remain in a precarious state.
Pakistan has no fiscal space and there is less room for counter
cyclical fiscal policy. In counter cyclical fiscal policy, taxes are cut
and spending is increased during downturns to promote economic
recovery and growth. Discretionary fiscal policy cannot be
adopted in Pakistan as public debt is high and government is
unable to finance the resulting fiscal deficit. Tax evasion is already
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on peak in Pakistan and as a result Pakistans tax to GDP ratio is
very low.
It can easily be concluded that GDP is one of the measures of
macroeconomic stability and regression results have made it clear
that Current Account Balance, Trade Deficit and even Inflation had
an impact on GDP. Multiple Regression Analysis has depicted that
Null Hypothesis should be accepted. Global Financial Crisis had a
severe impact on macroeconomic stability of Pakistan. Null
Hypothesis that high fiscal deficit decreased GDP growth has not
been justified by the regression analysis. Null Hypothesis that
widening of trade deficit has caused decline in GDP needs to be
accepted as shown by the regression results.
It has been established by research that GDP carries importance
in assessing macroeconomic stability. Regression results have
shown that potential impendent variables have an impact on GDP.

Current Scenario
Six years after the first tremors in 2007, the world looks rather
different. Interest rates are much lower. Risk pricing is much more
sharply differentiated. The threat of deflation is now real for
several countries, and inflation is very low for others. In most
advanced countries since the crisis, real per capita GDP growth
has been insipid at best. Although weak banks appear to be much
less of a problem in Australasia, impaired bank balance sheets in
the Northern Hemisphere are casting a long economic shadow.
The new environment creates some structural and strategic
challenges for the global financial industry. Much-reduced
financial engineering and weaker financial institutions are likely to
see some retrenchment of certain banking activities. Also, with
very low yields, financial institutions subject to obligations or
strong expectations to pay fixed returns (such as pension funds)
face pressure to increase holdings of risky assets, so they can
support these returns. A renewed search for yield for these
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reasons raises the risk of excessive investment or bubbles in such
lower quality assets.
Global spending and investment appear very cautious, and seem
likely to remain so for some time, given the overhang of debt from
before the crisis. In advanced economies, deleveraging in the
private sector appears to have started, but will take a long time
perhaps a generation. Very cautious households are a large part
of the story of a slow and fragile recovery. They have been hit
hard by sustained labor market weakness, and in the US and
some other advanced economies this has been compounded by
loss of housing wealth and balance sheet weakness.
In Europe, the prevailing perception is that the EU has now
reached a fork in the road. There is a clear understanding that the
real economy needs further structural change. Public finances
need to be put under control in countries that are breaching the
public debt threshold of 60 per cent of GDP. Better governance is
still needed in the banking, fiscal and economic areas. The EU is
currently making progress in all these areas and is focusing on
implementation. Consequently, the debt crisis can also be seen as
a healthy catalyst for improving economic governance in Europe.
Throughout its post-World War II history, crisis has been the
engine of progress in European integration.
The stronger hopes are due primarily to the more rapid output
and employment growth in the US economy that have come in
better than expected in late 2011. It now appears possible that
GDP in the United States might grow at a rate close to 3 per cent
in 2012, compared to 1.7 per cent in 2011. Moreover, for several
months, job creation has exceeded new entries into the labour
force, reducing unemployment to well below 9 per cent for the
first time since the employment plunge in 2009. While this is
modest progress compared to the challenge ahead it would
take almost a decade to reduce unemployment to pre-crisis levels
at the pace of recent months it has triggered a significant stock
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market surge, reinforcing a positive dynamic in the US economy.
Growth in the emerging and developing countries has slowed, but
still continues at a robust pace, with their internal growth
dynamics playing an increased role compared to their exports to
the advanced world.

Supplementary Reading

Report At a Glance
This report would try to explain the financial crises in a three part
scenario as follows:

Part I: How We Got Here


The American financial industry was regulated from 1940 to 1980,
followed by a long period of deregulation. At the end of the 1980s,
a savings and loan crisis cost taxpayers about $124 billion. In the
late 1990s, the financial sector had consolidated into a few giant
firms. In March 2000, the Internet Stock Bubble burst because
investment banks promoted Internet companies that they knew
would fail, resulting in $5 trillion in investor losses. In the 1990s,
derivatives became popular in the industry and added instability.
Efforts to regulate derivatives were thwarted by the Commodity
Futures Modernization Act of 2000, backed by several key
officials. In the 2000s, the industry was dominated by five
investment banks (Goldman Sachs, Morgan Stanley, Lehman
Brothers, Merrill Lynch, and Bear Stearns), two financial
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conglomerates (Citigroup, JPMorgan Chase), three securitized
insurance companies (AIG, MBIA, AMBAC) and the three rating
agencies (Moodys, Standard & Poors, Fitch). Investment banks
bundled mortgages with other loans and debts into collateralized
debt obligations (CDOs), which they sold to investors. Rating
agencies gave many CDOs AAA ratings. Subprime loans led to
predatory lending. Many home owners were given loans they
could never repay.

Part II: The Bubble


During the housing boom, the ratio of money borrowed by an
investment bank versus the bank's own assets reached
unprecedented levels. The credit default swap (CDS), was akin to
an insurance policy. Speculators could buy CDSs to bet against
CDOs they did not own. Numerous CDOs were backed by
subprime mortgages. Goldman-Sachs sold more than $3 billion
worth of CDOs in the first half of 2006. Goldman also bet against
the low-value CDOs, telling investors they were high-quality. The
three biggest ratings agencies contributed to the problem. AAArated instruments rocketed from a mere handful in 2000 to over
4,000 in 2006.

Part III: The Crisis


The market for CDOs collapsed and investment banks were left
with hundreds of billions of dollars in loans, CDOs and real estate
they could not unload. The Great Recession began in November
2007, and in March 2008, Bear Stearns ran out of cash. In
September, the federal government took over Fannie Mae and
Freddie Mac, which had been on the brink of collapse. Two days
later, Lehman Brothers collapsed. These entities all had AA or
AAA ratings within days of being bailed out. Merrill Lynch, on the
edge of collapse, was acquired by Bank of America. Henry Paulson
(U.S. Treasury Secretary) and Timothy Geithner (President of the Federal
Reserve Bank of New York) decided that Lehman must go into
bankruptcy, which resulted in a collapse of the commercial paper
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market. On September 17, the insolvent AIG was taken over by
the government. The next day, Paulson and Fed chairman Ben
Bernanke asked Congress for $700 billion to bail out the banks.
The global financial system became paralyzed. On October 3,
2008, President Bush signed the Troubled Asset Relief Program,
but global stock markets continued to fall. Layoffs and
foreclosures continued with unemployment rising to 10% in the
U.S. and the European Union. By December 2008, GM and
Chrysler also faced bankruptcy. Foreclosures in the U.S. reached
unprecedented levels.

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Important
Terminologies
Discussed
Bubble Economy:
A surge in the market caused by speculation regarding a
commodity which results in an explosion of activity in that market
segment causing vastly overinflated prices. The prices are not
sustainable and the bubble is usually followed by a crash in prices
in the affected sector.

Sub-prime mortgages:
A type of mortgage that is normally made out to borrowers with
lower credit ratings. As a result of the borrower's lowered credit
rating, a conventional mortgage is not offered because the lender
views the borrower as having a larger-than-average risk of
defaulting on the loan. Lending institutions often charge interest
on subprime mortgages at a rate that is higher than a
conventional mortgage in order to compensate them for carrying
more
risk.

Foreclosure:
The process of taking possession of a mortgaged property as a
result of someone's failure to keep up mortgage payments.

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Collateralized Debt Obligation (CDO):


A collateralized debt obligation (CDO) is a security that
repackages individual fixed-income assets into a product that can
be chopped into pieces and then sold on the secondary market.
They are called collateralized because the assets being packaged
-- mortgages, corporate debt, auto loans or credit card debt- serve as collateral for investors.
How It Works/Example:

CDOs are described as structured asset-backed securities


because they pay cash flows to investors in a prescribed
sequence, based on how much cash flow is collected from the
package
of
assets
owned.
The CDO is split into different risk classes known as tranches.
Interest and principal payments are made in order of seniority so
that senior tranches have the least risk. Junior tranches, which
have higher default risk, usually have higher coupon payments.
Collateralized debt obligations allow banks and corporations to
sell off debt and free up capital to re-invest or loan. The downside
of CDOs is that the loan originators have little incentive to collect
when loans in the package come due since these loans are now
owned by other investors. This may make originators less
disciplined
in
adhering
to
strict
lending
standards.
Another downside of CDOs is the complexity of these products.
Buyers may not know exactly what they are buying or whether
the package is really worth the price. The opaqueness and
complexity of CDOs can result in a market panic if investors lose
confidence and CDOs become more difficult to re-sell. This was
the scenario during the Sub-Prime Crisis of 2007 when many
banks were forced to take sizable write-downs on their CDO
holdings.

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Hedge funds:
Hedge funds are private, actively managed investment funds.
They invest in a diverse range of markets, investment
instruments, and strategies and are subject to the regulatory
restrictions of their country.

Mortgage-Backed Securities:
A type of asset-backed security that is secured by a mortgage or
collection of mortgages. These securities must also be grouped in
one of the top two ratings as determined by a accredited credit
rating agency, and usually pay periodic payments that are similar
to coupon payments. Furthermore, the mortgage must have
originated from a regulated and authorized financial institution.
Also known as a "mortgage-related security" or a "mortgage pass
through."
When you invest in a mortgage-backed security you are
essentially lending money to a home buyer or business. An MBS is
a way for a smaller regional bank to lend mortgages to its
customers without having to worry about whether the customers
have the assets to cover the loan. Instead, the bank acts as a
middleman between the home buyer and the investment markets.
This type of security is also commonly used to redirect the
interest and principal payments from the pool of mortgages to
shareholders. These payments can be further broken down into
different classes of securities, depending on the riskiness of
different mortgages as they are classified under the MBS.

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Adjustable-Rate Mortgage ARM:


A type of mortgage in which the interest rate paid on the
outstanding balance varies according to a specific benchmark.
The initial interest rate is normally fixed for a period of time after
which it is reset periodically, often every month. The interest rate
paid by the borrower will be based on a benchmark plus an
additional
spread,
called
an
ARM
margin.
An adjustable rate mortgage is also known as a "variable-rate
mortgage" or a "floating-rate mortgage".

Credit Default Swap (CDS):


A swap designed to transfer the credit exposure of fixed income
products between parties. A credit default swap is also referred to
as a credit derivative contract, where the purchaser of the swap
makes payments up until the maturity date of a contract.
Payments are made to the seller of the swap. In return, the seller
agrees to pay off a third party debt if this party defaults on the
loan. A CDS is considered insurance against non-payment. A
buyer of a CDS might be speculating on the possibility that the
third party will indeed default.
The buyer of a credit default swap receives credit protection,
whereas the seller of the swap guarantees the credit worthiness
of the debt security. In doing so, the risk of default is transferred
from the holder of the fixed income security to the seller of the
swap. For example, the buyer of a credit default swap will be
entitled to the par value of the contract by the seller of the swap,
should the third party default on payments. By purchasing a
swap, the buyer is transferring the risk that a debt security
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