Rostov-on-Don Department of education Gymnasium 34 Vladislav Pismenskiy Form 10 “Б” Research project in English Science Topic : Global Financial Crisis (GFC) or the «Great Recession“ Project supervisor : Dolgopolskaya I.B. 2012
The notion of economic crisis General grounds Causes of the crisis Impact on financial markets Global effects Stabilization Economic forecasting and media coverage Conclusion Outline
Global Financial Crisis (GFC) is claimed to be the worst financial crisis since the Great Depression of the 1930s by many economists. Problem
There is hardly ever any sphere of society that GFC didn’t touch. That’s why changes both in global economic relations and in the economy of a definite state and defining of the directions of further economic development have become urgent. Actuality
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 value. Financial crisis. What’s this? Financial crises recession or depression
The source of financial crisis of 2008 lies in the banking system of the USA. It concerned valuation and liquidity problems but the roots go back to 2007 which is considered to be the peak of housing bubble.
The International Monetary Fund estimated that large U.S. and European banks lost more than $1 trillion on toxic assets and from bad loans from January 2007 to September 2009. One of the first victims was Northern Rock, a medium-sized British bank. Impact on the financial markets
List of largest U.S. bank failures Bank City State Date Assets at time of failure WashingtonMutual Seattle Washington 2008 $307 billion IndyMac Pasadena California 2008 $32 billion Colonial Bank Montgomery Alabama 2009 $25 billion Guaranty Bank Austin Texas 2009 $13 billion Downey Savings and Loan Newport Beach California 2008 $12.8 billion Bank United FSB Coral Gables Florida 2009 $12.8 billion AmTrust Bank Cleveland Ohio 2009 $12.0 billion
For example, growth forecasts in Cambodia show a fall from more than 10% in 2007 to close to zero in 2009. This has stark implications and has led to a dramatic rise in the number of households living below the poverty line. Bangladesh — 300,000; Ghana — 230,000. Global effects
The recession that began in December 2007 ended in June 2009, according to U.S. National Bureau of Economic Research (NBER) and the financial crisis appears to have ended about the same time. Nevertheless, the lack of fundamental changes in banking and financial markets, worries many market participants, including the International Monetary Fund. Stabilization
The financial crisis was not widely predicted by mainstream economists, who instead spoke of the Great Moderation. A number of economists predicted the crisis, with varying arguments. A cover story in BusinessWeek magazine claims that economists mostly failed to predict the worst international economic crisis since the Great Depression of 1930s. Within mainstream financial economics, most believe that financial crises are simply unpredictable. Lebanese-American trader and financial risk engineer Nassim Nicholas Taleb warned against the breakdown of the banking system in particular and the economy in general owing to their use of bad risk models and reliance on forecasting and framed the problem as part of «robustness and fragility». Role of economic forecasting
Mass media focused great attention to the world financial crises. It has generated many articles, books, films etc. Trying to find the reason, the ways out of the crisis and those who are to blame for it. For example, Time Magazine named «25 People to Blame for the Financial Crisis» Media coverage
Emerging and developing economies drive global economic growth Rank Country GDP (billions of USD) Share of Global Incremental GDP Annualized GDP Growth World 14,331.570 100.00% 6.4% 1. China 3,494.240 24.38% 25.0% 2. United States 1,477.420 10.31% 8.4% 3. Brazil 1,139.740 7.95% 20.7% 4. Japan 1,036.140 7.23% 1.8% European Union 985.438 6.88% 1.5% 5. India 690.569 4.82% 15.0% 6. Russia 585.200 4.08% 11.3% 7. Australia 553.746 3.86% 14.5%
November 14, 2008 Leaders of the Group of Twenty (G20) gathered at an anti-crisis summit. Following the working session, the summit adopted a declaration in which general principles for reform of financial markets, the restructuring of international financial institutions, the obligation to refrain from the use of protectionist measures were proclaimed. Joint action of financial and political authorities
Summing up, the investigation outlined the reasons of the crisis and its consequences and mainly the fact that the stabilization and further development of financial market is possible only by joint efforts of all the leading economies. But the crisis turned out to be not so deep and the global financial system didn’t undergo crucial changes thanks to the interference of the state into the financial market. Though, not all the reasons were done away with economies of leading states still live under threat of the following crises. Conclusion
Thank you for your attention!
Causes of Global Financial Crisis
The current global financial crisis is in nature synchronised and once in lifetime. There are different views regarding causes of the current financial crisis which has gripped the whole world. Some attribute it to failure of regulators and policy makers others say it is financial institutions. Yet others put the onus on savings of emerging market countries especially China.
No doubt current crisis clearly reflect lack of vision on part of policy makers. The free market and deregulation mantra rigorously promoted by leading policy makers during the last decade shifted the attention of all stakeholders away from regulating even the riskiest and complex financial derivative instruments which are hardly comprehendible for anyone except few mathematical and statistical magicians. If there would have been even a reasonable level of oversight of these complex financial derivatives, things would not be that worse as they are today. The chart below gives a very high level overview of the increase in the notional amount of outstanding over the counter (OTC) derivatives that multiplied almost seven times from just USD 94 trillion in June 2000 to USD 683.7 trillion in June 2008 as reported by Bank for International Settlements.
Chart o/s otc derivatives june 2000 to june 2008
The ignorance of regulators even added fuel to the fire. Regulators are not just there to ensure compliance with existing laws but to identify and rectify any loopholes in the existing regulations. On one hand, US federal reserve kept the interest rates at very low levels for extended period of time in order to avoid natural downturn in the economy and thereby created abundant liquidity in the system and promoted a culture of extravagance and living beyond means. The world will not finance US consumer spending forever as the debt needs repayment which is not possible if you spend more than you earn. Savings as a percentage of household disposable income gradually decreased from 9% In 1980 to 1% in 2007 as published by Federal agencies which clearly reflect this culture. Even at one point in 2005 it went into negative zone which means US consumers were spending more than they were earning.
On the other hand, assumption that the financial market participants can look after their interests better than anyone else, promoted an illusion that there is no need to regulate the financial system. This assumption was flawed and completely ignored two factors, the element of competition in the financial services industry and greed. If I put myself into the shoes of those banking executives I might do the same as they did because if I adopt a conservative approach towards risk short term profitability will be hit and there would be huge pressure and criticism from various groups e.g. investors, media etc. regarding the performance of my organisation as compared to other market players. Though short sighted criticism by media or analysts does not prove legitimatecy for blind risk taking in order to boost short term profitability at the cost of long term survival of the organisation. Moreover, linkage between short term performance and remuneration packages of executives provoked them to take unusually high risk which produce huge profits in short term.
In addition to that, not only financial institutions but also credit rating agencies mispriced the risk. They failed to price risk attributable to externalities. The simplest example of pricing externalities is taking into account impact of failure of the organisation in question on the whole financial system e.g. in case failure of Citibank there will huge impact on the financial system as compared to failure of any small regional financial institution making it more expensive to bet on Citibank. Risks are generally mispriced not only in the financial services industry but also in other industries e.g. automobile industry, the price of a car only includes manufacturing cost plus margin, taxes etc. but the pricing mechanism does not take into account the cost of impact of that car on the environment and decline in the available energy resources.
Financial engineering has proved too expensive for the global economy so far. Complex derivative financial instruments like Credit Default Swaps (CDS) and Collateral Debt Obligations (CDO) no doubt increased the liquidity in the system but at the same time encouraged reckless lending practices e.g. sub prime lending and speculation.
CDO is a security whose principal and interest are repaid by the cash flows generated by a portfolio of assets (usually loans and bonds). The portfolio of assets is the collateral and it is usually in the balance sheet of a separate entity, called special purpose vehicle, which has the CDO as its only liability and the assets in the portfolio as its only assets. It is CDOs and similar financial instruments that enabled the originators of loans to sell loan portfolios and thereby increased the liquidity of the long term loans. It is interesting that a financial institution can now sell the loan it has originated to someone sitting at the other corner of the globe through instruments like CDOs thus transferring the inherent credit risk involved in the lending and promoted careless lending practices. This is simple logic which also applies at individual level e.g. if one knows he can sell the loan he lent to anyone and earn a profit then one will not hesitate to give the money even to a person to whom no one will lend a penny. This is what exactly happened in the case of sub prime lending.
CDS is an instrument in which the buyer makes periodic payments to the seller, and in return receives a compensation if an underlying financial instrument defaults. It is effectively insurance against default by the counterparty with the difference that in case of insurance insurer is regulated and adhere to insurance regulations e.g. capital requirements whilst in the case of CDS the writer or seller need not to be a regulated entity thus increasing the counterparty risk which in my view is a huge regulatory failure. Due to this flaw huge amount of CDS were sold by hedge funds without any consideration whether the entity will be capable to pay the compensation if it is required in the future. On top of that market participants bought and sold CDS for speculative purposes i.e. without having the underlying asset similar to short selling o f equities.The following table illustrate the outstanding notional amount of CDS and corresponding market values from June 2007 to June 2008. Though outstanding notional amount has just increased by 35% corresponding market values has soared to USD 3.1 trillion more than 4 times of market value at June 2007 that gives clear idea of increase in counterparty default risk since this crisis began. The recoverability of these USD 3.1 trillion is questionable if called.
Table CDS june 2007 to 2008
Savings of the emerging market countries especially China is said to be among one of the main causes of the current financial crisis. The main argument is that the savings of emerging markets have to find a home and instead of investment in the real economic assets they were made available to consumers in west notably Americans to mortgage a house or to buy a car etc. I can not understand the logic behind sky rocket hike in the price of a dwelling house which is not contributing to real economy. Almost all economists were agreed that the model of ‘Asians make it, Americans buy it’ is not sustainable in the long term and that Asians have to increase their domestic consumption in order to maintain economic growth in the long term. Whilst, Chinese savings were increasing sharply and reached to …. in …. US saving both on national and individual level was decreasing as noted above. One need not to be a rocket scientist to determine that one can not live on borrowing forever as one will loose his credibility sooner or later and Americans have to reduce consumption and increase savings. It is evident from the recent data that Americans saving rate at individual level has increased since the inception of the crisis from …. In jan 2008 To … in jan 2009.
No matter what are causes of the crisis there is no doubt about that we are in huge trouble. The vicious spiral of decrease in overall economic output, as demonstrated below, has begun and no one knows where it will end and how many will it take away with it. Interestingly, none of the five giant investment banks has sustained this crisis. Bear Stern and Merrill Lynch were acquired by JP Morgan and Bank of America respectively, Lehman Brothers gone bankrupt and the remaining two Goldman Sachs and Morgan Stanley changed their status from investment bank to deposit accepting institutions. We have witnessed events beyond imagination for instance freezing of commercial paper market, fall of stock markets by more than 40% in a year etc.
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