Sukkur IBA

University
Fixed Income Securities

Submitted To
Dr. Mujeeb Ur Rehman

Submitted By
Safi Ullah
BBA-7(B)
011-18-0047

Financial Crisis 2007-08

Dated:31/05/2021
Introduction
The Financial crisis of 2007-08 were one of the biggest financial crisis that
happened and many of the countries were effected badly. Great depression
cannot be forgotten as it is still considering the worst nightmare for the world. It
is started from United States, the largest financial market of world. Previously
there were small bubbles or no of recessions within the US, that lead to the
financial downfall. Bad and improper policies of housing bubble led to the
financial crisis. In result of that most of the people in the US got unemployed;
The remnants of the downfall are still plausible and perversive. The intervention
of the government through bailouts and nationalization stopped the recession
becoming the second Great Depression. However, its effect had already become
pervasive. economic growth stagnated; some institutions declared bankruptcy;
stock prices plummeted, and stock markets plunged; the confidence in the
markets faded; Eurozone recessions or European Debt Crisis emerged; the
domino effect of the mortgage markets swept other financial institutions and
markets, and the global output declined. The financial Crisis of 2007-08 had hit
the world so badly and still many of the countries took so much time to recover
that.

Mortgage Crisis and USA

It is true to say that the mortgage crisis was done by the two groups which were
investors and homeowners. Homeowners were the investors who had the houses
while On the other hand, investors had money that represented the group of
financial institutions like Sovereign, Mutual, Hedge, Pension Funds, and
Insurance companies.. Here is how. Some years ago, the investors had a lot of
money to earn profits or proceeds. For the safest investments, they used to
resort to the US treasury for the fixed income securities like The US Treasury
Bonds, Notes, and Bills. However, because of the dotcom bust and September
11 events, the Federal Reserve Chairman, Allen Greenspan, decreased interest
rate up to 1% so that the economy could be on the track of improvements. The
investors decided not to invest in the Treasury Bills.

For example, you want to own a home. For that, you must save for a down
payment and then approach the mortgage broker. The broker, in turn, becomes a
bridge between you and the lender, a bank, who will give you a mortgage. After
the contract, a broker earns a commission, you own a house, and the lender gets
monthly payments. Now, the investors approached the lenders to get mortgages.
Without hesitation, the lenders sold the mortgages to investors with handsome
fees. After this sale, the lenders or investment banks approached the Federal
Reserve for more money at cheap rates for purchasing more houses for
mortgages.

The investment bankers scratched the crazy idea, that is, they thought that the
prices of the houses always increased. Thus, it would be great if they allowed
the mortgages to people without down payments, income proof, and other
documents because later, they could foreclose the home and sell it to the market
at a higher price. However, the investment banks came up with the problem
when they found that all those who qualified for the mortgage had already
mortgage. Thus, the costs could have been recovered. In other words, instead of
lending to responsible people, irresponsible homeowners were chosen. This was
known as subprime mortgage instead of prime. The issuance of the subprime
mortgages was the turning point. The same process of buying and selling took
place in the market. Everyone was transferring the risk through the sale of
mortgages. If homeowners became the default, it would be a problem for
mortgage holders to recover the losses. Thus, they asked the banks to foreclose
their houses. Now, instead of principal plus interest in the trenches, the
investment bankers were holding a pool of houses having no worth at all.
Owing to the lower house prices, the homeowners thought it would be great to
buy a home from the market without huge interest and principal payments.

Reasons for Mortgage Crisis

There are multifarious reasons for mortgage Crisis. Some of them are
mentioned below.

Interest rates Fluctuations

The Fed changed the federal funds rate several times during May 2000 and
December 2003 until the rate became 1% from 6.5%. Federal Funds Rate is the
type of interest rate in which the banks charge one another for overnight loans
of the Fed. The Federal Reserve Chairman, Alen Greenspan, lowered the
interest rate to combat the dot-com bubble and the September 11 attacks or
shocks and the risk of deflation. This decline in rate caused the banks to do
more consumer financing and include the subprime borrowers charged with
higher interest compared to prime borrowers. However, between July 2004 and
July 2006, The Fed increased the interest rates substantially, which increased
the one-year and the five-year adjustable-rate mortgage (ARM). Thus, the new
ARM rates were severe shocks for the homeowners, and the signs of recession
were visible from there. Cheap credit allowed the consumers to purchase more
and more houses, appliances, and other durable items. Resultantly, the housing
bubble was created, which burst later in the form of a recession.

Huge lendings
When the mortgage lenders found that there was not any qualified borrower left,
they chose to approach the unqualified persons for mortgages due to higher
competition and dire demand from investors. Before 2003, Government-
Sponsored Enterprises were used to oversee the compliance of mortgage
standards and rules. Subprime lending increased substantially because of the
relaxation of lending policies by investment and commercial banks. Because of
the tough competition, the GSE relaxed the lending policies to compete with the
private sector. The radical shift in market dynamics from securitizers to
originators subdued the powers of GSE. The mortgage standards were relaxed,
and subprime loans became pervasive. In US history, the period 2004 to 2007 is
said to have the riskiest loans.

Ineffective regulatory bodies and poor laws

There were times that rules and regulation were heavily violated by these. Some
of the quoted examples are given below to understand it better.

 Gramm-Beach-Billey Act signed by Bill Clinton repealed the Glass-

Steagall Act. This act removed the barriers between investment banks and
commercial banks. Universal risk-taking banking model was introduced.
 The relaxation of net capital rule by the US Securities and Exchange
Commission precipitated higher leverage or debt by banks for mortgage-
backed securities.
 Any credit risks without having any underlying debt instruments.
 Depository Institutions Deregulation and Monetary Control Act of 1980
lessened the powers of depositors by increasing and broadening the
powers of banks, thereby providing the opportunities of hedging risks to
banks.
 Garn-St Germain Depository Institutions Act signed by Ronald Regan
introduced adjustable-rate mortgage loans and banking deregulation.

Bubbles Created By Houses

A giant pool of money having $70 trillion in Fixed Income securities across the
world had earned more yields than the US Treasury Bonds. This housing bubble
was the result of the consumers choosing to refinance at lower interest rates and
get the secured mortgages with price appreciation. Within the span of 8
years(1998 to 2006), the typical American home prices soared by 124%, and the
national median home price was in the range of 4 to 4.6 times median
household income. The crazy Wall Street bankers brought the pool of money
into the US mortgage markets. The giant pool of money had become double in
size; however, the fixed income securities had not developed enough. To earn
on this money, Wall Street Players, especially Investment Banks, came up with
the idea of mortgage-backed securities and having ratings.

Mortgage Crisis and Spillover Effects on other Financial Markets

The mortgage crisis had effected other financial markets so badly. Remember
that these securities were based upon subprime loans lent by investment and
commercial bankers. As the subprime borrowers started getting default because
of spikes in interest rates and plummeting housing prices, banks no longer
traded those securities in financial markets for investors. Mortgage loans were
securitized through the process called Collateralized Debt Obligations by Wall
Street Bankers and these mortgage-backed securities were left for trading in the
financial markets like mortgage markets. In other words, the process of
securitization was at its peak. Resultantly, the financial markets lost confidence
because of the lack of principal and interest payments coming from mortgage-
backed securities, and the crisis spilled over these markets. So, the mortgage
crisis have not only effected the other financial markets but it has also had it
spillover to these institutions.

Mortgage Crisis and Spillover Effects on US Economy

US economy is considered to be one of the biggest economy of the world as it
has huge GDP and large number of businesses operating in it. $8 trillion were
wiped out or withdrawn from the plummeting US stock markets because of less
volume of trading and the loss of investors’ confidence. The crisis had very
serious impacts on the US economy. Unemployment reached 10% by October
2009 because many big players declared bankruptcy, and some other firms had
declared stagnant growth; the common American saw their $9.8 trillion wealth
lose because of drop-in house prices; the bank failures caused the credit
shortage which hindered investment and corporate operations in the country; the
real gross domestic product(GDP) fell miserably in the third quarter of 2008 and
4.3% by 2009, it was dropping at the rate which was never ever happened in the
US history since 1950s; capital or residential investment dropped drastically due
to asset price deflation; the consumption or domestic demand fell by record;
poverty rate surged from 12 to 15%; $16 trillion was lost by all American
households together; and trade and industrial production and their exports were
cut short because of lack of letter of credit issuance by banks. The mortgage
crisis had also effected the US economy and its GDP had decrease and many of
the people became unemployed. But it recovered after some years.

Crisis origin and spillover to global Economy

Globalization was in emergence when the financial crisis of 2007-08 was faced.
Some of the people argue that the financial crisis was due to the globalization of
the world.The global economy is interconnected through financial globalization.
In the 1970s, financing through financial markets increased vastly. With this
development, trans-border financial transactions were possible in almost every
country because the governments started deregulating financial operations
locally and internationally. This financial mobilization helped connect the
global financial markets. When subprime borrowers got default in the US, the
value of mortgage-backed securities fell miserably throughout the world. In
addition to that, the global stock markets are interconnected through stocks,
bonds, and commodities. Then, there came the domino effect of the stock
market crash of every country. When the US companies did not have demand
because of lack of money and fears, the US consumers were not consuming
foreign products, thereby leading to a crisis for the exporting countries as their
products had no demand at all. As a result, the stock prices of the exporting
companies fell. The stock markets began to crash and the overall economy was
falling down so that it was uncontrollable.
Financial crisis had huge impacts on the global economy. It had lower down the
economic activities and increased the inflation. The crisis affected all countries
either directly or indirectly; however, some countries were deeply affected by
the recession. And other countries that had severe effects were Iceland, Mexico,
Hungary, Russia, and the Baltic States. The following graph shows the most
affected countries. The extent of the crisis in the foreign countries (other than
the US) was measured through devaluation of the currency, the decline in the
equity market, and a surge in the government's bond spreads. Many of the other
countries economy were faced downfall and took too much time to recover.

Many of the banks in Europe had invested in mortgage-backed securities based

upon subprime loans in the US. Take the example of Iceland which was on
brink of collapse because there came the recession, the government debacle
happened, and the three largest banks were taken into the government’s
custody. Overall, Europe was hard hit by the recession because of its strong
interconnectedness with the US. Developing countries faced a huge downfall
because of their export of commodities and other products, and the advanced
economies, including the US, were not severely affected because of their
resilience and strong capital, and current account surpluses. After Iceland, there
came the rainy days over Spain, Portugal, Greece, Italy, and Ireland. In these
countries, the government declared themselves bankrupt, which is known as the
Sovereign Debt crisis or European Debt Crisis. Even though the US was the
epicentre of the financial crisis, it had fewer effects of the crisis than other
developing countries and emerging markets. In short, the global output fell
drastically. The overall markets of the world had fall and it had huge impacts on
developing countries. So these countries were affected highly than those which
had stable economy.

The Responsible of Financial Crisis

Regulatory bodies were ineffective, and it will not wrong to blame the
regulatory bodies for financial crisis. The most crucial factor stopping the
recession was the regulatory bodies. Because of the negligence of regulatory
institutions and lobbying practices from the financial players, there came a
change in policies that relaxed the ease of predatory lending and leverage. As
discussed in the reason ‘Lack of regulatory actions and deregulation of laws,’
many policies were manipulated by the financial players to leverage their
interest. The second example is that the US Securities and Exchange In short,
lack of regulatory actions and deregulation of laws were the main reasons or
stakeholders of the financial crisis. For instance, the Depository Institutions
Deregulation and Monetary Control Act of 1980 gave the banks absolute power
to gamble the depositors’ money. Now, the depositors had a lack of surveillance
over banks. The lobbyists bribed the politicians to enact this law. Thus, it
reflects the regulatory blunders. The law and order were not effective and the
banking system was poor. So, the working govt could not see crisis coming
down because of the poor law and order system.

Prevention of Such Crisis in Future

No doubt the crisis might occur in future if the some of the measures in regards
of such crisis had not be taken. By having a control environment through
effective regulatory bodies and having a good law and order system such crisis
can be lower down. They have to debt reinflation should strictly be prohibited.
The countries should not do a huge accumulation of debt. The money supply
should not be deflated suddenly. According to financial analysts, corporations
should not be allowed to remove mortgage-backed securities through the
process of structured investment vehicles. The laws, Glass-Steagall Act and
Commodity Futures Modernization. In this way, investment banks and
commercial banks can be distinguished. The banking sector should comply with
Basel 3 of the International Bank of Settlements. Derivatives should be either
strongly regulated or banned, for they cause greater losses to the economy since
they do not contribute to real economic growth. Net capital requirements should
be set to the right limit. In other words, the higher leverage should be
discouraged. Subprime loans should not be given at any cost. There should be
proper documents of assets and income while lending to any person. The
interest rates should not be the lowest surprisingly or immediately like the
Federal Reserve did. By focusing on underwriting the next financial crisis can
be lower down and we can be safe to face such crisis again.

Conclusion
It is really hard to understand this complex financial system and rule it out.
These regulatory failures precipitated the financial crisis that swept the world.
Many people are of the view that it is a systematic fault in capitalism, for it has
produced the two worst crises in history. The irony is that the country of origin
had lesser impacts than the other countries, especially some European and
emerging markets and developing economies. In this complex financial system
because of the advent of new financial products, there is a requirement for
strong regulation. Deregulation does not mean the worst decision to allow banks
to operate freely; however, it aims to maximize the greed in bankers in form of
higher leverage and then predatory lending. Many economists were predicting
such a situation long before; their views were strongly rejected. Financial
globalization caused the effects of the recession to spread across the globe.
Unfortunately, the corporations or Wall Street Players made the mistake, but the
public paid the price, or they became the scapegoat of the crisis because the
Bush administration provided a $700 billion bail-out package from taxpayers’
money to avoid the further collapse of the financial system. People who were
involved in shaping this crisis got away with it or went with impunity. The next
Financial crisis can be stopped by strong law and order and credible regulatory
bodies.