Case Study financial crisis In The US

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1. Introduction
The global financial crisis is a topic that occupied the minds of many researchers and specialists;
in order to search for the actual reasons behind the occurrence; detection of the reasons is the
secret knowledge of the solution. The financial crises has an obvious effects on the changes of
the macroeconomic and microeconomic variables. twenty-first century has witnessed the world
financial crisis that began and appearing in 2007, and its implications extend to the present time,
has left a clear negative impact on the output level, the level of employment, the level of
individual incomes, and The negative impact on financial markets; that prompting many people
to try to search for the real causes of the crisis, especially since the contagion swept most parts of
the world.

The financial crisis that has been wreaking havoc in markets in the U.S. and across the world
since August 2007 had its origins in an asset price bubble that interacted with new kinds of
financial innovations that masked risk; with compa nies that failed to follow their own risk
management procedures; and with regulators and supervisors that failed to restrain excessive risk
taking.

A bubble formed in the housing markets as home prices across the country increased each year
from the mid 1990s to 2006, moving out of line with fundamentals like household income. Like
traditional asset price bubbles, expectations of future price increases developed and were a
significant factor in inflating house prices. As individuals witnessed rising prices in their
neighborhood and across the country, they began to expect those prices to continue to rise, even
in the late years of the bubble when it had nearly peaked. (Martin Neil Baily, 2008)1

The paper is organized as follows: the first section addresses and identify global financial crisis
and its types, causes and consequences of the global financial crisis, in the second section we
will discuss the financial market performance through study hypothesis of efficient market and
role of information and types of financial market efficiency.

In the third section we will discuss the impact of financial crisis on the financial market and
ways to solve problem result of financial crisis, finally we will draw our conclusion about US
financial crisis.

1
Martin Neil Baily, R. E. (2008). The Origins of the Financial Crisis. Business and Public policy
, PP.7.
Causes And Consequences Of Financial Crises
- Housing Demand and the Perception of Low Risk in Housing Investment

The driving force behind the mortgage and financial market excesses that led to the current credit
crisis was the sustained rise in house prices and the perception that they could go nowhere but
up. Indeed, over the period 1975 through the third quarter of 2006 the Office of Federal Housing
Enterprise Oversight (OFHEO) index of house prices hardly ever dropped (Martin Neil Baily,
2008)2.

What began as a bursting of the U.S. housing market bubble and a rise in foreclosures has
ballooned into a global financial and economic crisis. Some of the largest and most venerable
banks, investment houses, and insurance companies have either declared bankruptcy or have had
to be rescued financially. In October 2008, credit flows froze, lender confidence dropped, and
one after another the economies of countries around the world dipped toward recession. The
crisis exposed fundamental weaknesses in financial systems worldwide, and despite coordinated
easing of monetary policy by governments and trillions of dollars in intervention by central
banks and governments, the crisis seems far from over. (Donnelly, 2008)3

- Deregulation of Financial Markets

Rising inflation in the United States prompted foreigners to lose confidence in the U.S. dollar as
the leading currency and to seek security by purchasing gold. FED unlinked the dollar from gold
and adopted a regimen of floating interest rates. This created greater volatility in the financial
system as well as increased opportunities to earn higher interest rates.(MISHKIN,2008)4

Significant societal changes and developments in technology combined to serve as a catalyst to

propel deregulation.5

2
Martin Neil Baily, R. E. (2008). The Origins of the Financial Crisis. Business and Public policy
, PP.7.
3
Donnelly, M. (2008). The U.S. Financial Crisis: The Global Dimension with Implications for
U.S. Policy. CRS REPORT FOR CONGRESS , PP. 37.
4
Mishkin, F. S., 2008, Does Stabilizing Inflation Contribute To Stabilizing Economic Activity?
NBER National Bureau of Economic Research, Inc.
5
Removed many government restrictions on financial institutions in the United States and
other countries
According to Simon Johnson 6argues that from the confluence of campaign finance, personal
connections, and ideology flowed a river of deregulatory policies. These included:

1. Insistence on free movement of capital across borders

2. The repeal of Depression-era regulations separating commercial and investment banking

3. Decreased regulatory enforcement by the Securities and Exchange Commission

4. Allowing banks to measure their own riskiness

5. Failure to update regulations to keep up with the tremendous pace of financial innovations.

1.1.1. Financial Innovations

Financial innovations, designed by brilliant computer experts to manage risk and make capital
less expensive and more available, ultimately led to the global financial crisis. Financial
innovations, with instantaneous global impacts due to technologies that made electronic
transactions faster and less expensive, raced ahead of regulations. Complex financial products
created in one financial center involved assets in another and were sold to investors in a third
financial market.

Prior to the widespread use of securitization, banks, many of them local, provided loans to
customers they often knew, and the banks were responsible for the risks involved in making
loans. This meant that bankers gave loans only to individuals and companies they believed could
repay the loans. With securitization, 7 risks inherent in granting loans were passed from the bank
giving the loans to others who had no direct interest in the customers ability to repay the loans.
Subprime mortgages, student loans, car loans, and credit card debts were securitized.
(MISHKIN,2008)8

- Executive Compensation

Excessive executive compensation is widely perceived as playing a pivotal role in creating the
global financial crisis. Wall Street became a magnet for the brightest Americans who wanted to

6
Simon Johnson, The Quiet Coup, The Atlantic, May 2009, 52.
7
Financial engineering designed to reduce risk
8
Mishkin, F. S., 2008, Does Stabilizing Inflation Contribute To Stabilizing Economic Activity?
NBER National Bureau of Economic Research, Inc.
make a large amount of money very quickly. Most companies rewarded short-term performance
without much regard for market fundamentals and long-term earnings. Executives were given
stock options, which they could manipulate to earn more money. The more an executive could
drive up his or her companys stock price or its earnings per share, the more money he or she
would get.

Frank Partnoy ,(2003) argues that a mercenary culture developed among corporate executives.
They merged with or acquired higher-growth companies and, in many cases, committed
accounting fraud.

This fraud led to the bankruptcy of companies such as Enron, Global Crossing, and WorldCom.
Many executives received long prison sentences. (MISHKIN,2008)9.

- Low Interest Rates

A fundamental cause of the global financial crisis was the easy availability of too much money
globally. An oversupply of money created unprecedented levels of liquidity and historically low
interest rates. the terrorist attacks on the United States on September 11, 2001, triggered a
national embrace of increased government spending as well as consumer spending. To
accomplish this, the U.S. Federal Reserve, lowered interest rates to around 1 percent in late 2001.

The U.S. government encouraged Americans to purchase homes and to refinance or borrow
against the value of homes they owned. As consumers and the government lived beyond their
means, they were able to borrow from developing countries that were accumulating huge
reserves from the phenomenal growth of global trade. (MISHKIN,2008)10.

- Subprime Loans

Another major cause of the financial crisis was the availability of subprime loans, which were
directly an outgrowth of easy credit. Subprime loans generally refer to credit given to individuals
who fail to meet rigorous standards usually expected by lending institutions. These individuals
could not really afford their loans because of inadequate income and poor credit histories. In

9
Mishkin, F. S., 2008, Does Stabilizing Inflation Contribute To Stabilizing Economic Activity?
NBER National Bureau of Economic Research, Inc.
10
Mishkin, F. S., 2008, Does Stabilizing Inflation Contribute To Stabilizing Economic
Activity? NBER National Bureau of Economic Research, Inc.
most cases, borrowers were not required to have a down payment. With excess liquidity globally,
interest rates remained low. People with weak financial histories are generally more vulnerable to
being charged higher interest rates. For example, poor people pay exorbitant rates for payday
loans. A basic reality of finance is that yields on loans are inversely proportional to credit quality:
the stronger the borrower, the lower the yield, and vice versa.20 Driving the demand for
subprime loans was the development of a culture of entitlement and a false egalitarianism that
appealed to peoples egos. Home ownership was pushed by the U.S. government as an
inalienable right, despite borrowers inability to repay loans. (MISHKIN,2008)

- Speculation

A combination of low interest rates, unprecedented liquidity, and a belief that the Internet and
various computer technologies virtually guaranteed unending and Fannie Mae and Freddie Mac j
U.S. government corporations involved in real estate adjustable-rate mortgage A long-term loan
that has varying interest rates. ever-increasing prosperity facilitated the growth of speculative
financial forces. Excessive risk taking replaced caution, which was often equated with a lack of
optimism. (MISHKIN,2008)

Conclusion

The rapid rise of lending to subprime borrowers helped inflate the housing price bubble. Before
2000, subprime lending was virtually non-existent, but thereafter it took off exponentially. The
sustained rise in house prices, along with new financial innovations, suddenly made subprime
borrowers previously shut out of the mortgage markets attractive customers for mortgage
lenders. Lenders devised innovative Adjustable Rate Mortgages (ARMs) with low teaser
rates, no down payments, and some even allowing the borrower to postpone some of the interest
due each month and add it to the principal of the loan which were predicated on the expectation
that home prices would continue to rise.
Question 1
year Cash Present value of $1 = (1/ Present
Flow (1+r)^n value of
cash flow
1 10000 0.91
9090.909
2 15000 0.83
12396.69
3 20000 0.75
15026.3
Present value
36513.9

We accept project if the PV of cash inflow > PV of cash out flow ( cost of
investment Or NPV >0

But in this question there's no cost of investment to suggest whether project

acceptable or not.

Question 3
 year Cash Present value of annuity = (1- Present
Flow (1/(1+r)^n))/r value of
cash flow
0 -6500 1 -6500
1-6 1200 4.62 5547.4556
Present value -
952.544403

The project rejected because NPV<0