Financial Crisis - Impacts and Reactions

Table of Contents

1. Introduction

2. Collapse of the Financial Markets

3. Impacts on Financial Institutions

4. Impacts on German Economy and Companies

5. Monetary Reactions by the German Government

6. Conclusion

References

1. Introduction

For the last couple of years the world has been experiencing one of the most severe financial crises ever. This has been compared to the Great Depression of 1929. Starting with the Mortgage crisis in the USA in 2007 and the collapse of Lehman Brothers in September 2008, this problem increased to the worst global economic crisis ever. The negative effects of the Global Financial Crisis from 2007-2009 are both financial and real. The financial impact of the crisis resulted in problems in the banking systems of many countries. The real impact was that economic growth slowed down. The crisis bought many challenges and questions concerning the ability of the industries in the national economies to survive, the destiny of the employees and the role of the government in the current market situation. The crisis, could create opportunities for some industries if the companies are not misled by the general negative moods towards the current state of the market.

The following essay gives an overview of the Global Financial Crisis, its challenges and monetary reactions.

2. Collapse of the Financial Markets

The Financial Crisis began with the credit crisis. This was a direct result of failure from a mortage market in the U.S.The problem started in 2001, when the Federal Reserve of America (Fed) decided to lower the interest rate from 6.5% to 1%, in order to overcome the negative affect of September 11th on the growth of economy.¹ The FED action accompanied with influx of money from growing China and the Middle East has resulted in abundance of credit in the United States. Financial investors represented by the Investment Banks and Wall Street companies were looking for solid return on their investment beyond the FED 1% interest rate. They capitalized on the opportunity presented by the growing mortgage market in the U.S.A The abundance of credit has encouraged many Americans to buy their own houses by obtaining loans from Mortgage Lenders such as Fannie May and Freddy Mack. The excessive lending has increased demand for new houses as more Americans entered the mortgage market.

The result was a boom in the Real Estate market from 2002-2006, with houses prices almost tripling during this period. Mortgage companies packaged these loans and sold them to Investment Banks which in turn categorised these loans according to their risks and sold them as financial derivates under different names and returns to investors around the world. In essence, the risk has been shifted from Mortgage lenders to Investment Banks and then to the financial investors. The scheme was risky, but as long home owners are paying their monthly instalment, everything seemed normal and acceptable.

To ensure Mortgage Lenders did not to run out of credit worthy applicants, they began to attract risky applicants with bad credit history. They used schemes such as no down payment, no proof of income and no credit check to lure new applicants to create a boost. The justification behind Sub-Prime loans was that even if some risky applicants defaulted, their collateral (houses) can be sold to someone else for a higher price. This can be true, only if a few applicants default frequently., The default rate with Sub-Prime loans was higher than anticipated and Investment Banks were holding too many houses,but no buyers could be found. The excess of supply over demand has burst the bubble, and housing prices began to drop in 2006- 2007 in many parts of the U.S., refinancing became more difficult. As home prices failed to rise, defaults and foreclosure activity increased with adjustable mortgage rates resetting much higher rates.

The decline in prices has also induced Prime Loan owners to default, since it is not worthy to make payments on cheap houses. During 2007, foreclosure activity increased approximately to 1.3 million, up 75% from 2006.² Loan defaults in the U.S. not only threatened the solvency of U.S. financial institutions but also triggered the current turbulence in global credit markets with far-reaching social, economic and political effects. The crisis has left many U.S. mortgage borrowers without home ownership Several mortgage lenders, investment banks and securities firms filed for bankruptcy or has been acquired by the government or other firms. Collapse of major institutions like Lehman Brothers and AIG led to a serious crisis of confidence in the U.S. financial system.

As defaults on payments swept the country, Investment Banks and investors ended up with huge loans and worthless houses. Conversely, Mortage Lenders can´t find new applicants and cannot sell their loans to investors.

3. Impacts on Financial Institutions

From the outset of the U.S. subprime financial crisis and the subsequent credit crunch, many U.S. and European banks such as Citigroup, Bear Stearns, HSBC, Deutsche Bank, Lehman Brothers and UBS reported severe losses. The International Monetary Fund estimated that large U.S. and European banks lost more than $ 1 trillion on toxic assets and from bad loans during January 2007 to September 2009. These losses increased to top § 2.8 trillion from 2007 to 2010.³ One of the first victims was Northern Rock, a medium sized British Bank. The highly leveraged nature of its business led the bank to request security from the Bank of England. This in turn led to investor panic and a bank run in mid September 2007. Calls by Liberal Democrat Treasury Spokesman Vince Cable to nationalise the institution were initially ignored. In February 2008, however, the British government relented, because they failed to find a private sector buyer.The bank was taken into public hands after receiving financial aid from the Bank of England.⁴ Northern Rock´s problems proved to be an early indication of the troubles that would soon befall on other banks and finanicial institutions.

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¹ Federal Reserve Board: Monetary Policy and Open Market Operations.

² Realtytrac.com: U.S. Foreclosure Activity Increases 75 Percent in 2007

³ Bloomberg-U.S.: European Bank Writedowns & Losses-November

⁴ Bank of England, News Release: Liquidity Support Facility for Northern Rock