Introduction about Financial Crisis

The term financial crisis is applied broadly to a

variety of situations in which some financial
institutions or assets suddenly lose a large part of
their value1.

The financial crisis of 2007–2008, initially referred

to in the media as a "credit crunch" or "credit crisis"2,
began in July 20073 when a loss of confidence by investors in the value of securitized
mortgages4 in the United States resulted in a liquidity crisis that prompted a substantial
injection of capital into financial markets by the United States Federal Reserve and the
European Central Bank.

Historical Background of Recent Global Financial Crisis

Historical background of recent financial crisis may be categorized as follows:

1. Credit Crunch & Housing Bubble: The stock price plunge and severe credit
crunch we are watching today in global financial markets are byproducts of the
developments in the US six years ago. In late 2001, fears of global terror attacks after
9/11 shook an already struggling US economy, one that was just beginning to come
out of the recession induced by the bursting of the dotcom bubble of late 1990s.

In response, during 2001, the Federal Reserve, the US central bank, began cutting
interest rates dramatically to encourage borrowing, which spurred both consumption
and investment spending. As lower interest rates worked their way into the
economy, the real-estate market began to get itself into frenzy. The number of homes
sold and the prices they sold for increased dramatically, beginning in 2002. At the
time, the rate on a 30-year fixed rate mortgage was at the lowest levels seen in nearly
40 years.

Subprime and similar mortgage originations in the US rose from less than 8% of all
mortgages in 2003 to over 20% in 2006.

The crisis began with the bursting of the US housing bubble and high default rates on
subprime and adjustable rate mortgages, beginning in approximately 2005-2006. For
a number of years prior to that, declining lending standards, 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.

1 http://en.wikipedia.org/wiki/Financial_crisis
2 Larry Elliott (August 5 2008). "Credit crisis - how it all began suddenly, one August day last
year shook the world, turning an Edwardian summer of prosperity into a grim financial crisis".
The Guardian
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3 Wall Street Journal. "TED Spread spikes in July 2007". Wall Street Journal

4 Floyd Norris (August 10, 2007). "A New Kind of Bank Run Tests Old Safeguards". The New York

Times
2. Rise in Interest Rate & Housing Price: However, once interest rates began to
rise and housing prices started to drop in 2006-2007 in many parts of the US,
refinancing became more difficult. Default and foreclosure activity increased
dramatically as easy initial terms expired, home prices failed to go up as anticipated,
and adjustable rate mortgage interest rates reset higher. Foreclosures accelerated in
the United States in late 2006 and triggered a global financial crisis through 2007 and
2008.

3. Fall of Construction & Mortgage-lending Institutions: Initially the companies

affected were those directly involved in home construction and mortgage lending.
Financial institutions, which had engaged in the securitization of mortgages, fell prey
subsequently. Bear Stearns’ stock price fell from the record
high $154 to $3 which was the acquisition
price by JP Morgan Chase, subsequently the acquisition
price was agreed on $10 between the US government as
well as JP Morgan. On July 11, 2008, the largest mortgage
lender in the US, IndyMac Bank, collapsed. Government
attempted to save mortgage lenders Fannie Mae and Freddie Mac, which it did by placing
the two companies into federal conservatorship on September 7, 2008 after the crisis
further accelerated in late summer.

4. Fall of Non-mortgage lending Financial Institutions: It then began to affect

the general availability of credit to non-housing related businesses and to larger
financial institutions not directly connected with
mortgage lending. At the heart of many of these
institution's portfolios were investments whose
assets had been derived from bundled home
mortgages. Exposure to these mortgage-backed
securities, or to the credit derivatives used to
insure them against failure, threatened an
increasing number of firms such as Lehman
Brothers5, AIG, Merrill Lynch, and HBOS6. Other
firms that came under pressure included Washington Mutual7, the largest savings and
loan association in the United States, and the remaining large investment firms,
Morgan Stanley and Goldman Sachs8.

5 "Lehman Files for Bankruptcy; Merrill Is Sold" article by Andrew Ross Sorkin in The New York
Times September 14, 2008
6 "Pain Spreads as Credit Vise Grows Tighter" article by Louis Uchitelle in The New York Times

September 18, 2008

7 "Washington Mutual Is Said to Consider Sale" article by Geraldine Fabrikant in The New York
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Times September 17, 2008

8 "As Fears Grow, Wall St. Titans See Shares Fall" article by Ben White and Eric Dash in The New

York Times September 17, 2008

5. Initiating Big-budget Supportive Program by some Governments: Many
financial institutions in Europe also faced the liquidity problem that they needed to
raise their capital adequacy ratio. As the crisis developed, stock markets fell
worldwide, and global financial regulators attempted to coordinate efforts to contain
the crisis. The US took $700 billion bailout plan and the UK launched a £500 billion
bailout plan aimed to injecting capital into the financial system. The British
government nationalized most of the financial intuitions in trouble. Many European
governments followed as well as the US government. In the Eastern European
economies of Poland, Hungary, Romania, and Ukraine the economic crisis was
characterized by difficulties with loans made in hard currencies such as the Swiss
franc. As local currencies in those countries lost value making payment on such loans
became progressively difficult.

As the financial panic developed during September and October, 2008 there was a
"flight to quality" as investors sought safety in U.S. treasury bonds, gold, and strong
currencies such as the dollar and the yen. This currency crisis threatened to disrupt
international trade and produced strong pressure on all world currencies.

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