Recession HelpCrisisHelper
Home Features Try Free Order About Affiliates/Resellers

 

Financial Crisis of 2007–2009


This article is about the series of financial market events, starting in July 2007, which were the proximate cause of a weakening of the global economy. For details on the stock market crashes and bank bailouts of late 2008, see Global financial crisis of 2008–2009. For economic issues beyond the financial markets, see Late 2000s recession. For discussions of major aspects of the policy response to the crisis, see The Keynesian Resurgence of 2008 / 2009 and 2009 G-20 London summit.

The financial crisis of 2007–2009 began in July 2007[1] when a loss of confidence by investors in the value of securitized mortgages 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, Bank of England and the European Central Bank.[2][3] The TED spread, an indicator of perceived credit risk in the general economy, spiked up in July 2007, remained volatile for a year, then spiked even higher in September 2008,[4] reaching a record 4.65% on October 10, 2008. In September 2008, the crisis deepened, as stock markets worldwide crashed and entered a period of high volatility, and a considerable number of banks, mortgage lenders and insurance companies failed in the following weeks.

Although America's housing collapse is often cited as having caused the crisis, the financial system was vulnerable because of intricate and highly-leveraged financial contracts and operations, a U.S. monetary policy making the cost of credit negligible therefore encouraging such high levels of leverage, and generally a "hypertrophy of the financial sector" (financialization). [5]

200

(2007-2009) WORLD FINANCIAL CRISIS

Crisis Map Description Countries in official recession (two consecutive quarters)
Countries in unofficial recession (one quarter)
Countries with economic slowdown of more than 1.0%
Countries with economic slowdown of more than 0.5%
Countries with economic slowdown of more than 0.1%
Countries with economic acceleration

(2007-2009) CRISE FINANCIÈRE MONDIALE

Crisis Map Description Pays en récession officielle (deux trimestres consécutifs)
Pays en récession non officielle (un trimestre)
Pays avec ralentissement économique de plus de 1.0%
Pays avec ralentissement économique de plus de 0.5%
Pays avec ralentissement économique de plus de 0.1%
Pays avec accélération économique

Scope

The crisis in real estate, banking and credit in the United States had a global reach, affecting a wide range of financial and economic activities and institutions, including the:

  • Overall tightening of credit with financial institutions making both corporate and consumer credit harder to get;[6]
  • Financial markets (stock exchanges and derivative markets) that experienced steep declines;
  • Liquidity problems in equity funds and hedge funds;
  • Devaluation of the assets underpinning insurance contracts and pension funds leading to concerns about the ability of these instruments to meet future obligations:
  • Increased public debt public finance due to the provision of public funds to the financial services industry and other affected industries, and the
  • Devaluation of some currencies (Icelandic crown, some Eastern Europe and Latin America currencies) and increased currency volatility,

The first symptoms of what is now called the late 2000s recession ensued also in various countries and various industries. The financial crisis, albeit not the only cause among other economic imbalances, was a factor by making borrowing and equity raising harder.

Background

The previous major financial crisis occurred in 1928 to 1933. A financial crisis occurs when there is a disorderly contraction in money supply and wealth in an economy. It is also known as a credit crunch. It occurs when participants in an economy lose confidence in having loans repaid by debtors. This causes lenders to limit further loans as well as recall existing loans.
The financial/banking system relies on credit creation as a result of debtors spending the money which in turn is 'banked' and loaned to other debtors. As a result a relative small contraction in lending can lead to a dramatic contraction in money supply. The Great Depression occurred after a dramatic expansion in debt and money supply in the roaring twenties. Total US private credit market debt as a percentage of GDP reached 250% in 1929. The next time debt exceeded this level in the USA was in 1999 reaching a peak of 350% prior to the bubble bursting.


A dramatic contraction then occurred between 1929 and 1933 as debt was defaulted upon and resulted in a 'contraction' in money and wealth. The debt deflation theory coined by Irving Fisher formed the basis of the regulation subsequently introduced by Congress.


The Glass-Steagall Act was passed by Congress in order to prevent this occurring again. It was found that financial firms encouraged debt to be invested in the stockmarket which then overheated the stockmarket. The act was designed to prevent this by separating the advising from the lending role of financial institutions. Following its repeal by Congress in 1999, institutions could advise and lend setting up a direct conflict of interest in many 'deals'.
The framework which created the great depression from a regulatory point of view were 're-created' by the repeal of this act. Financial firms could profit in the short term by simply setting up and lending on deals using others money.
A sequence of rapid debt expansion occurred including a dot-com bubble, which was followed by an equity and housing bubble and then a commodity bubble. Without the debt expansion which measured $14 Trillion USD some analysts have argued that there would have been no economic growth in the USA between 1996 and 2006.


The Global financial crisis is the unwinding of the debt bubbles between 2007-2009.

Cause of the financial crisis

In August 2002 an analyst identified a housing bubble.[8] Dean Baker wrote that from 1953 to 1995 house prices had simply tracked inflation, but that when house prices from 1995 onwards were adjusted for inflation they showed a marked increase over and above inflation-based increases. Baker drew the conclusion that a bubble in the US housing market existed and predicted an ensuing crisis. It later proved impossible to convince responsible parties such as the Board of Governors of the Federal Reserve of the need for action.[dubious – discuss][9][10] Baker's argument was confirmed with the construction of a data series from 1895 to 1995 by the influential Yale economist Robert Shiller, which showed that real house prices had been essentially unchanged over that 100 years.[11]


A common claim during the first weeks of the financial crisis was that the problem was simply caused by reckless, sub-prime lending. However, the sub-prime mortgages were only part of a far more extensive problem affecting the entire $20 trillion US housing market: the sub-prime sector was simply the first place that the collapse of the bubble affecting the housing market showed up.

The role of central banks

Some have proposed that the crisis is an excellent example of the Austrian Business Cycle Theory, in which credit created through the policies of central banking gives rise to an artificial boom, which is inevitably followed by a bust. Proponents of this theory have predicted the current financial crises, and argue that central banks should not be involved in debt markets.
The history of the yield curve from 2000 through 2007 illustrates the role that credit creation by the Federal Reserve may have played in the on-set of the financial crisis in 2007 and 2008. Treasury yield is one tool of monetary policy.


The yield curve (also known as the term structure of interest rates) is the shape formed by a graph showing US Treasury Bill or Bond interest rates on the vertical axis and time to maturity on the horizontal axis. When short-term interest rates are lower than long-term interest rates the yield curve is said to be “positively sloped”. This in turn encourages an expansion in money supply and in turn favours debt induced bubbles. When long-term interest rates are lower than short-term interest rates the yield curve is said to be “inverted”. This favours a contraction in money supply. When long term and short term interest rates are equal the yield curve is said to be “flat”. The yield curve is believed by some to be a strong predictor of recession (when inverted) and inflation (when positively sloped).


Other observers have doubted the role that monetary policy plays in controlling the business cycle. In a May 24, 2006 story CNN Money reported: “…in recent comments, Fed Chairman Ben Bernanke repeated the view expressed by his predecessor Alan Greenspan that an inverted yield curve is no longer a good indicator of a recession ahead.”


A positively sloped yield curve allows Primary Dealers (such as large investment banks) in the Federal Reserve system to fund themselves with cheap short term money while lending out at higher long-term rates. This strategy is profitable so long as the yield curve remains positively sloped. However, it creates a liquidity risk if the yield curve were to become inverted and banks would have to refund themselves at expensive short term rates while losing money on longer term loans.


Following the bursting of the Dot-com bubble in 2000 and the Stock market downturn of 2002 the US Federal Reserve reacted by sharply lowering short-term interest rates. The Fed lowered the Fed Funds target rate beginning in January 2001 at 6.5% to a nadir of 1% in June 2003. The Fed also held rates at this low level for an unusually long period of time (1yr) until June 2004. This prolonged period of stimulative Federal Reserve monetary policy created a very positively sloped yield curve. The yield on the 3-month T-bill reached its lowest point (0.88%) for the cycle in the late fall of 2003 while at the same time 30-year T-bond rates were in excess of 5%.


The inflationary effect of the prolonged period of a very positively sloped yield curve resulted in inflation of asset prices rather than a general increase in the price level of all goods and services. The reason this happened was likely due to the cheap goods that were imported from BRIC economies prevented any inflation. The excess money was channeled into various assets. Without a globalised economy this may not have happened. In particular, it led to a United States housing bubble that began to attract attention as early as 2002 but reached its peak in 2005.


In June 2004 the Fed began to slowly increase Fed Funds rates and the yield curve slowly narrowed. Fed Chairman Alan Greenspan notably described this narrowing of spreads between short term and long term rates as a “conundrum” during testimony in February 2005. The chairman expected long term rates to rise in line with short term rates. However, the tightening of monetary policy caused by rising short term rates was slowing the economy and reducing demand for long-term borrowing.


The Fed raised Fed Funds target rates to a peak of 5.25% in June 2006. By October 2006 the yield curve on 90-day T-bills vs 30-year T-bonds was essentially flat indicating neutral monetary policy (neither stimulative nor contractionary). While the Fed maintained Fed Funds rates at this high level, long term rates began to fall causing the yield curve to become more and more inverted. The yield curve was most strongly inverted in March 2007 when concern about current inflation was reaching its peak.

The role of central banks

Some have proposed that the crisis is an excellent example of the Austrian Business Cycle Theory, in which credit created through the policies of central banking gives rise to an artificial boom, which is inevitably followed by a bust. Proponents of this theory have predicted the current financial crises, and argue that central banks should not be involved in debt markets.
The history of the yield curve from 2000 through 2007 illustrates the role that credit creation by the Federal Reserve may have played in the on-set of the financial crisis in 2007 and 2008. Treasury yield is one tool of monetary policy.


Try CrisisHelper for FREE! Order CrisisHelper Today,Get $110 of FREE Bonuses

Sign Up For Our FREE Anti-Crisis Newsletter and Receive FREE, Our eBook With 50 Ways to Cut Expenses:
Email address:

©20082009 CrisisHelper.com, First Aid In Tough Times of World Economic Crisis
Free eBook[X]