FINANCIAL CRISIS

2007-2008
Submitted to Dr. Archana
Done by
Naomy Nasambu Simiyu
2K18/MBA/128
FINANCIAL CRISIS 2007-2008
The On set of the Crisis

• The financial crisis in the USA was fuelled in the real estate industry whereby
the prices for the real estate were soaring and everybody thought it was a good
form of investment to engage in so the financial institutions were compelled to
offer more of the mortgage loans without considering the security of the loans,
the interest rate charged on them and also the repayment plan which most of
the loaned could not meet.
• Firms that guaranteed the security of the instruments found that their net
worthy disappearing leading to increased concerns to financial institutions which
were dependent on the guarantees.
• During the same period hedge funds introduced the risk of high volatility which
exposed investors to sudden shock.
• Banks were forced to obtain equity capital in order to meet the regulatory
requirement and maintain the confidence of the depositors.
• Recession seemed inevitable in amid of all the central bank’s effort to reduce
interest rates and to increase financial liability.

Expectations of the financial institutions
• Escalating property values would create
equity
• Market interest would not rise abruptly
• Home owners would able to adjust if
needed to
What really happened
• The sub-prime loans were packaged with
other instruments into collateralized debt
obligation (CDOs) or asset backed
commercial paper(ACP).
• Others countries which were decoupled
from the US feared following suit into
recession.
• The various central banks reduced the
interest rates to increase liquidity of the
their economies.
• US introduced a cut on personal taxes
through a tax refund program.
• Some institutions offered guarantee to some debt offering to pay if there were a
default; but many of them were unable to honour their guarantees.
• Many financial institutions started providing the same new instruments as
introduced in the US and as the defaults began it was then hard to value the
instruments hence the monoline guarantors became insolvent leading the market
back to illiquidity.
• With the new financial instruments the banks had three options: it could hold a
loan in a specific purpose vehicle off its balance sheet or it could sell the loan to
others or it could pay another company to accept loan repayment default. The
analysts compared each of these options and found there was lack of
accountability, lack of responsibility and lack of transparency.
• An estimation of half of the world’s debt was by then passing through the hands
of the non bank financial institution and hedge funds were facing increased
volatility and huge losses after taking position in commodity markets and foreign
exchange markets.
 • It started as a result of the introduction of the sub-prime
mortgages which spread globally across other financial
institutions whose worth was not defined.
• Relaxation in the lending regulations since one the repayment
schedule was not realistic, the interest charges were inflated
but the banking regulation system did not take any step to
control the selling of the sub-prime loans.

• Lack of proper flow of information in the economy through the

credit rating agencies that gave very good ratings for such financial
instruments which was not genuine so many people resolved in
investing in the same and in the end faced a lot of losses because of
the same.
• Lack of coordination: by establishing this Framework, the G20
focuses at the highest level, and makes members accountable at
every summit meeting for progress towards their shared objectives
HOW WAS THE SITUATION HANDLED?

• The central banks rushed to offer short term loans to provide finances to
the financial institutions.
• The central bank in the US provided 150M$ in tax refund at 600$ per
person in April 2008.
Different Institutions and the decisions they undertook
Hedge funds
Hedge funds referred to Investment vehicles that were meant to deal with the
current financial instrument. The Sub-prime crisis lead to:
• closure of a number of hedge funds as a result of domino effect.
• The banks that had lent money to the hedge funds pulled back and demanded
more security for their loans this forced hedge funds to sell their assets at
whichever prices they got hence leading to losses.
Insurers of the debt

• With the collapse of many debt obligations that these firms did not have adequate
capital to fulfil their guarantee process.
• Monoline industries one of these service providers later on experienced a fall in
the global ratings this lead to concerns about their ability to honour their
guarantees. The illiquidity threatened the ability of many borrowers to the raise
capital required.
 BANK RECAPITALIZATION

• Different banks were affected the financial crisis various of them resolved to
certain measures to survive
1. Citigroup reduced its balance sheet by 2 trillion through selling some of its
non-core assets
2. AIG sought some fresh 12billion capital for a start to restructure its
balance sheet
3. Canadian bank revolved to search for new investors.
(In the US the home loans were financed by the Federal National Mortgage Association)
Central Banks
The central banks intervened to reduce the liquidity in the market through.
The federal was financial stability regardless of the future threats of inflation while
on the other side the central banks sought to prevent inflation by all means.
In April 2008 the banks launched a special liquidity scheme and was prepared to
swap assets that could trade easily in return for their illiquid assets.
The scheme involved:
1. No cap was placed on the amount of assets
2. The swaps would be available at any bank anytime for six months
3. Loans would last as long as a year and would be renewed for as long as
three years
Steps to be taken( suggestions by US treasury Hank Parkson):
1. The several existing regulatory agencies to be coordinated through the creation
of the Federal National origination commission. But the critics argued that
might create a new layer of bureaucracy
2. The new agency to help regulate banks and step in to financial institution as need
arises. Many still argued that there should be one overarching regulator of the
financial system in the country.
Martin Wolf Presented The Seven C’s As Principles To Be Followed In
Creating New Agency:

• Cushion: should have capital required and also the expenditures related to
equity by the financial institution
• Cover: contain all financial institution
• Commitment: the originating and selling model had failed but is required
to hold the ongoing equity loans to be sold.
• Cyclicality: institutions to be required to achieve capital and liquidity ratios
on average from time to time in order to reduce volatility.
• Clarity: transparency must be improved and credit rating agency operate with
diligence.
• Compensation: senior management of institutions to bear losses individually
when there is losses in the financial institution.
• Complexity: make it a requirement that all financial instruments be traded on the
exchange markets in order for market forces to impact their prices instead of
prices being determined through negotiation.
Impact of Steps taken:

• Increased threats of inflation as a result of the central bank’s actions to counter

the financial crisis.
• Prices of fuel were also skyrocketing which also influenced the prices of food
products.
• Increase in demand for food which was as a result of increase in agricultural
products which would be used in manufacture of gasoline as alternative method.
• Decrease in purchasing power as a result of price escalations
• Due to threat of job and investment losses the consumers might react to
it by reducing their expenditure hence leading the economy into
recession.
Points to note:
There is close relationship between the financial system and the economy as a
whole.
• Its now not clear whether the monetary policy or the fiscal policy could maintain
the economic stability alone.
• There is need for setting up new regulations that should be international n nature
.
LESSONS LEARNT
PRIVATE SECTOR/INVESTORS

• originators need to be "incentivized" to make loans to high-quality

borrowers and to monitor loan performance more carefully to avoid
mean assumptions that might cause a fortune.
• the governance structure of the risk management system needs to be
improved in financial firms in which the incentives are biased toward
returns rather than the risks involved in attaining them. Thorough research
should be done to ensure the evaluation is correct.
• the incentives to use credit rating agencies and the incentive structures
within credit rating agencies themselves need to be reexamined.
• investors need to perform their own due diligence and ask the right
questions about the riskiness of the securities they are purchasing or
employ brokers specialized in such areas to do the analysis for them as
they have both experience and know-how.
 PUBLIC SECTOR

• There is need to refine the regulatory framework to avoid distorted incentives.The

desires of private sector investors and the actions of the intermediaries were indeed
influenced by the regulations they faced.
• supervisors and regulators need to have the incentives and resources to look hard and
deep at possible flaws in the risk management systems of the institutions they oversee.
• how to cope with the outcomes of crises of this new type. Bank resolution and
deposit-insurance frameworks need to be strengthened and interagency coordination
needs to be more effective.