Lecturer: Ilia Botsvadze

STUDENTS: Nini Mamulashvili

Tina Sikharulidze

The 2008 world financial Tamuna Papaskiri

crisis
 The 2008 world financial crisis

Many economists consider the 2008 financial crisis as the worst economic disaster after the Great
Depression of 1929. It led to the great recession in global economy and even today, more than 10 years
later, we can’t exactly say how much did it cost to world economy. We will take a closer look to background,
causes and final consequences of this crisis.

Some important events, which included overall deregulation for financial intermediaries by USA
government and fed, creating government sponsored enterprises such as “Fannie Mae “, “Freddie Mac”
and 2001 recession, created background for 2008 crisis. Deregulation refers to several acts that had a
strong influence on banking system. These acts were: Gramm-leach-Bliley act and commodity futures
modernization act of 2000.

The Gramm–Leach–Bliley Act is an act of the United States Congress (1999–2001). It removed
limitation in the market between banking companies, securities and insurance companies that prohibited
any institution from acting as any combination of an investment bank, a commercial bank, and an insurance
company. President Bill Clinton was the one who signed this legislation into law. Many of the largest banks,
brokerages, and insurance companies demanded the act at the time and they justified themselves with the
fact that individuals usually put more money into investments when the economy is doing well, but they put
most of their money into savings accounts when the economy turns bad. With the new Act, people would
do both 'savings' and 'investment' at the same financial institution and these financial institutions would be
able to do well in both good and bad economic times. (Jolina C. Cuaresma, 2002)

The Commodity Futures Modernization Act of 2000 officially regulated financial securities,
which are known as over-the-counter derivatives.Over-the-counter (OTC) derivatives are securities that
are traded directly between two parties of this agreement, without going on a stock exchange or to other
intermediaries. Contractslike swaps, forward exchange rate agreements, options – and other derivatives –
are usually traded in this way. The OTC derivative market is mostly unregulated because the negotiation
takes place between two parties; As a result, itbecame difficult to estimatevalue of the products that are
traded on OTC market, because trades occur in private, unlikely to stock exchange. This act was signed into
law on December 21, 2000 by President Bill Clinton and the most significant consequence of it was that it
allowed financial intermediaries to trade between each other with derivatives such as credit default swaps,
CDOs and others. (Colleen M. Baker, 2010)

In 1968, U.S. Congress founded government-sponsored enterprises (GSE), Fannie Mae and
Freddie Mac. Their function was to create a liquid secondary market for mortgages. This meant that financial
institutions no longer had to hold the mortgage loans they lent; it was possible to sell them on the secondary
market after origination. This enabled banks to sell their mortgages and then make new mortgages with that
money. (Kevin R. Kosar, 2007)
 The 2001 recession has to be taken into consideration when we are talking about stage for 2008
crisis. Actually, it has its origin in 1999, because there was an economic boom in computer and technology
sales. Many companies and individuals as well bought these new technologies to make sure their software
were meeting contemporary requirements. High demand on them led the stock price of many high-tech
companies to increase. Investors' began buying the stocks of any high tech company, whether they were
profitable or not. It became apparent that this boom on technology would decline someday as companies
had already bought all the equipment they would need. As a result, the stock market started to drop in
March 2000. Therefore, value of these technology companies declined and they went bankrupt.
The Federal Reserve ignored the situation on the market and continued raising interest rates. The fed funds
rate reached 6.5 percent by May 2000 but the economy needed low rates for cheap credit. The 11.09.2001
attack definitely worsened the situation. Even New York Stock Exchange has been closed for four trading
days after this attack. Unemployment reached almost 6% percent in December 2001. (Kevin L. Kliesen)
That rate was higher than usual and the Bush administration tried to end this recession with expansionary
monetary policy. Central banks around the world tried to stimulate the economy. They tried to increase
liquidity in the market by lowering of interest rates. In December 2001, Federal Reserve Chairman Alan
Greenspan lowered the fed funds rate to 1.75 percent in December, then nearly to 1.25 percent in 2002.
(FED, 2002)

So to sum up, at the end of 2002, commercial banks had a right to act as an investment banks, this
means they could trade with every security and derivative and mortgage loan. At this time fed rate was at
1.25%, so investors wouldn’t invest in government issued securities, because they were earning too low
interest, so they started to look for other, different ways to make investments. USA government gave banks
opportunity to get higher and higher revenues this way, it was just necessary to come up with a way that
would provide funding for more and more securities for banks to sell them. They looked for other sources,
such as derivatives and exotic loans. It was no problem to issue securities, but they should have been
backed by something to attract investors. At that time, the only industry, in which prices kept rising, was the
housing industry. Demand on housing was high, as American people were buying houses with mortgage
loans and this fact made financial intermediaries think to back their securities with mortgages, because they
were stable and safe source of income. Therefore, the process of securitization began.

Firstly, Investment banks bundled mortgages and made new type of security - a mortgage-backed
security (MBS).This means they made security, which was secured by a mortgage or even with collection
of mortgages. They paid their owners periodic payments, like coupon payments of a bond. So this means
banks were paying borrowers of this securities some amount of mortgage payment(s) they were getting
from mortgage loans. MBS did not turn out to be enough for investors. Banks made so much money by
selling these securities, that they even created a new security - 'Collateralized Debt Obligation - CDO'- it
was financial product that pooled together MBS, it was called collateralized because it consisted of MBS,
which were considered as safe investment. However, of course,not every CDO wasof the same quality,
they consisted of different MBS and different mortgages.All debtors have different ability to pay the lender
back and they have different probability to default. So, credit rating agencies gave different evaluations to
these CDOs. Rating system consisted of different data, for example: the monthly payments, total amount
owed, the likelihood that borrower would repay, past experience of this borrower and so on. Because of the
difference, these securities were “sliced” into “tranches” and they caught cash flow of interest or principal
payments in sequence - based on their ratings. CDOs were divided into “AAA, AA, A, BBB, BB, B, CCC,
CC, C” rating. If some loans default and CDO is unable to pay all of its investors, those with the lowest
ratings- “C, CC, CCC” suffer losses first. The last to lose payment from default are the safest tranches with
rating of – “AAA”. This means CDOs with rating of “AAA” had theoretically no risk to default, because every
payment from mortgages would go firstly to them. So CDOs had different risks and “Risk-Return trade off ”
tells us that the higher is your risk, the higher interest you earn, so CDOs which had lower credit rating
offered you more interest. (wikipedia.com)

Creating CDOs wasn’t the last step of the securitization process. Different financial institutions
made various securities based on CDO- futures, options, swaptions, synthetic CDO (several CDO in one
security) and even Insurance companies (one of the biggest insurance companies is AIG) involved in this
situation with their 'Credit Default Swap - CDS'. In a credit default swap, the buyer of the swap makes
payments to the swap’s seller until the maturity day of a contract. In return, the seller agrees that, in case
if the debt issuer defaults the seller of this swap will pay the buyer the security’s premium as well as
all interest payments that would have been paid between that time and the security’s maturity date. We can
assume that CDS were designed to transfer the default risk to a third party, but they were considered almost
riskless as their risk was considered to be the default of CDOs. So the investors took all the risk of default.

To sum up, there is a product on the market (CDOS) that is backed with both real estate and
insurance and they have high rating as well.The real problem with CDOs was that buyers couldn’t price
them correctly. They were complicated and new.Credit rating agencies gave CDOs rating that bank
needed(otherwise, they would not pay them money). At this time, the stock market was booming. Everyone
wanted to make money and they bought these securities based on nothing more than word of mouth, so
all financial intermediaries: banks, insurance companies and others wanted to buy more and more CDOs.
Result of this was that CDO sales raised almost 10 times (900%) from $30 billion in 2003 to $225 billion
in 2006. (Carl Levin & Tom Coburn, 2011)

Mortgages, MBS and CDOs created a chain. Firstly, people were paying mortgages, and some
percentage of these payments were going to borrowers of MBS and from these payment, owners of CDOs
took their share. Everyone took its cut on the way so everyone was satisfied.

Everything is ok, the system works, but we know that nothings is unlimited. Sooner every prime
mortgage was used up and banks needed mortgages to make the securities, which generated high profit.
Banks demand on mortgages grew and grew which led to derivation of subprime mortgage crisis. Banks
had guarantee that every mortgage loans they made could be sold to GSEs, converted into securities or
sold to hedge funds (institutions that pools together investor’s investments and invests these money in
different assets, securities and derivatives). In order to meet this demand banks and brokers offered home
loans to just anyone and these “anyone-s” were unlikely to repay their loans, this means they had high risk
of default and lower credit rating. These types of loans are called subprime mortgages. Banks also offered
interest-only loans to those, who could not afford other mortgages. (It allowed borrowers to pay just
interest rate for the first few years). As a result, the number of subprime mortgages dramatically increased
from 173 billion in 2001 to a 665 billion in 2005, and nearly 20% of all mortgages were subprime. This was
the main reason for creating abubble in real estate.

As we know, an asset bubble is created when the price of an asset becomes over-inflated. Prices
rise quickly over a short period. They are not supported by an underlying demand for the product itself. As
we mentioned, banks and hedge funds created a huge demand for mortgage-backed securities, mortgages
are available for everyone and demand on housing was greater than supply, as a result, we get high prices
on houses. We know that the big part of mortgages were subprime at that time, and these “subprime
borrowers” slowly stopped paying interest rates to banks, homeowners just couldn't afford these payments
anymore. The banks had to take those houses from their borrowers, which were collateral for these
mortgages. In fact, houses are good collateral for mortgages, but whom can you sell them to when most of
people already have mortgages and can’t afford to buy a new house? This was the reason why supply of
housing exceeded demand on them, consequently prices started to fall down. By September 2008, average
US housing prices had declined by over 20% from their mid-2006 peak. As housing prices fell, other
borrowers who could still pay for their mortgages stopped paying, because they could see that market
prices of houses, which they were paying for, was less than their mortgage. They defaulted. (Ronald W.
Melicher, 2011)

How subprime mortgage crises grew into financial one? In fact, the basic of every security, as we
mentioned were the mortgage loans. Mortgages were no longer paid and owners of MBS could no longer
get their payments, the same was for owners CDOs because CDO was nothing more than several MBS
together and default of CDO led to default of every derivative that were made based on them, In time,
everyone owned them. Not only investment firms and hedge funds had made huge losses when their
collateralized debt obligations and mortgage backed securities defaulted, there were also smaller
institutions and private investors who placed their money in CDO’s to profit from interest earnings.
Especially retirement funds and public employee pensions, who invested in the most secure tranche of a
CDO, almost lost all of their money. Also Insurance companies had to pay huge premiums and fees to
owners of CDS and everyone had to pay money, but there was no actual money in this situation and
explosion of these derivatives led to Banking crisis, which grew into Wall Street and then global financial
crisis in 2008.

Banks who owned big amount of these assets began to panic. They realized they would have to
pay for losses and had liquidity issues at the same time. They stopped helping and lending each other and
lending each other money, they didn’t need any worthless mortgages as collateral, but the most necessary
thing was cheap credit. It was time for central bank to interfere and act as a lender of last resort. In 2007,
FED started increasing liquidity in the banking system. In March, fed announced that it would provide banks
with 200 bln $ for 28 day loans on March 10 and 24. It was closed process and banks who used discount
window could stay unknown because they did not want public to know they used it. It was not enough. (Ben
Bernanke, 2009)

One of the investment banks Bear Stearns had invested 10 trillion $ in securities and if it would go
under, all these securities would become worthless and it would drag world economy into crisis. So on
march 17, Fed had its emergency meeting – it was first case during past 30 years and made sure to
guarantee Bear Stearns bad loans, costing 30 bln $, so that JP Morgan (bank) could buy it.By the end of
July, fed had already lent 1.45 trillion $ to help the monetary system. (Ben Bernanke, 2009)

In July, FED realized that something had to be done with GSE: Fannie Mae and Freddie Mac.
These GSE bought mortgages from banks and then repackage these into MBS and sell to different
investors. In addition, they had totally guaranteed more than 500 billion of MBS. If these loans would
bankrupt, their shares would depreciate and this would make it more difficult for the private companies to
raise capital by themselves. Moreover, the treasury department spent 150 billion $ to subsidize and
purchase Fannie Mae and Freddie Mac. (Ben Bernanke, 2009)

At this time, on July 11, the IndyMac bank was allowed to fail. It was one of the largest savings
and loans association and its failure is estimated as the fourth largest bank failure in the USA. People
panicked, The treasury secretary Paulson reassured people that banking system was working quite well,
IndyMac might have failed, but Federal Deposit Insurance Corporation insured deposits which were up to
100 000 $. Nevertheless, about 100 people thought that they would lose their deposits because FDIC as
they were more than 100 000 $ and then FDIC revised this amount up to 250 000 $. (wikipedia.com, n.d.)

After this, FED and treasury refused to bailout wall street andone of the largest investment banks
at the time, Lehman Brothers became the biggest “casualty” of this financial crisis. Of course, the reason
of this was that Lehman had built itself a large portfolio of mortgage-backed securities which were
decreasing in value, and since the acquisition of Bear Sterns, investors were worried about the wellbeing
of Lehman, fearing that it too could come close to failure. This worry turned into a lack of confidence in the
firm which in turn drove their stock down by 77% in the first week of September 2008, but that was just the
start. There were two volunteers Barclay’s and Bank of America that could buy Lehman, but Paulson
refused to guarantee billions of dollars for uncertain mortgage assets. Treasury secretary didn’t think that
it was right that government took all the responsibility for financial markets. Government had alreadymade
bailout for Bear Stearns and GSEs and he though Lehman wasn’t large enough to damage global economy,
so it was allowed to sink.
 As Lehman brother bankrupted, investors of Merrill lynch were afraid that this fail would affect
other investment banks as well, so they started thinking to sell Merrill lynch in order to save their investments
from losing. The result of this was that Merrill lynch sold itself to Bank of America.

Paulson was wrong to think that treasury would not have to make sacrifice any more. AIG had
insured trillions of mortgage loans with their credit default swaps. They made huge losses on these swaps
and their bankruptcy meant all the agents who had invested in would lose their money, so global banking
system would fail. The Federal Reserve spent 85 billion $ to take over largest insurance company in USA-
AIG. Later this number rose to 150 billion $. (Ben Bernanke, 2009)

Last but not list, as the financial downturn in the US continues, the recession started to spread
globally. The world economy is nowadays linked together very close and interactions between
companieshave become an ordinary thing. In late 2008 the world stock market reacted to the crisis with a
huge fall. In Europe several subsidiaries and offices of the banking companies had to close and, banks in
Germany as well, for example had to be rescued by the government as they had also invested heavily in
American real estate securities. 15 out of the hugest global corporates around the world had to consume
less and spend less because they either lost money or feared to lose their jobs. As a consequence of that,
exports especially in the US collapsed, which affected suppliers from China and Japan. Highly dependent
from the US market, Chinese manufacturers faced problems as their major markets stopped to invest and
reduced demand. Only in China more than 10 million migrant workers lost their jobs. In the meantime,
unemployment’s rates in the world “shot up” to 7.2% compared to 5.9 % in past year. (World Bank, 2017)
( It was the highest value since the 70’s.) The recession had reached almost every sector of the world
economy. Actually the world GDP from 2006-51.307 trillion $ raised to 57.793 trillion $ in 2007 and it again
increased to 63.386 trillion $ in 2008 and finally, it decreased to 60.087 trillion $ in 2009. So approximately
3.3 trillion dollars were lost. (World Bank, 2017). Even world leading firms like G.M and Chrysler who had
employed together more than 280.000 people almost faced bankruptcy and also had to be rescued by
government funds. (Financial Stability Department, 2009)

The world financial crisis of 2008 influenced almost the whole world and Georgia was not an
exception of course. It should be noted, that Georgia was harmed by the Russian-Georgian war of August
in 2008, more than world financial crisis. Also, we should recognize slight development of the financial
sector of Georgia and lesser involvement in the global financial network. Based on that fact, we can say,
that the direct impact of the crisis was minimal. On the other hand, the world financial crisis influenced the
prices of ores and metals on the international markets. Ores, metals and metal scrap was the main export
goods of Georgia at that time, so the decreasing of the prices hit to Georgia's export revenue very much.

Also, the impact of the crisis on Georgia's balance sheet was very important for our country. Foreign
investments and money transfers from abroad were significantly reduced.
 Both of the events, world financial crisis and internal economic crisis have had a negative impact
on the Georgian banking sector. In 2009, the total assets of the banking system as well as total liabilities
have decreased and income on assets and equity become negative.

The world financial crisis had good effects on Georgia too. World prices for fuel and food have
significantly decreased during the crisis and it was a positive impact for Georgia's current balance deficit. It
should be noted, that at that period the prices of real estate have fallen. However, it is hard to say exactly
what the real reason was for that. It could be global financial crisis, or the internal economic crisis caused
by the August war. (ბაქრაძე, 2009)

To sum up all above-mentioned information, we can definitely say that financial crisis, maybe not
directly, but affected every average people in the world. Households stoppedto consume significantly as
consumer confidence fell, thus this reduced consumption. Consequently, the profits of many firms fell,
meaning that they began to lay people off and hence unemployment increased exponentially. Households
had a lower disposable income or had to sign up for unemployment benefits.

In addition, the crisis affected businesses worldwide as the demand for their goods and services
fell on account of consumers being reluctant to spend due to uncertainty regarding the state of the economy
and job prospects. Thus, the financial crisis affected the economy globally – the total value of goods and
services produced fell worldwide. So, unemployment rose in many countries and government revenues fell
during the financial crisis. Therefore, the crisis resulted in a global downturn in economic activity, causing
increases in unemployment, a fall in businesses profits and increases in government’s budgets
deficits.Unfortunately, average people were the ones who had to carry this crisison their shoulders,
because every $ that government paid to save companies, or central bank paid to bailout different banks,
were the money that people had paid in form of taxes.
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