NINJA Loans to Blame for Financial Crisis- September 19th, 2008 by Kenneth Long

The housing crisis is finally boiling over into financial markets, creating turmoil that
threatens some of the oldest and most established financial institutions. To blame are
greed and ineffective mortgage regulations that allowed the crisis to become so
widespread. Specifically, the focus of these problems center around no documentation
or stated income mortgage loans which are affectionately known as NINJA loans.
What is a NINJA Loan?
A NINJA loan is a description of mortgage loan that originated without the important
documentation to prove that the applicant can reasonably adhere to the loan terms. It
stands for No Income, No Job or Assets.
Many of these loans were based on unsubstantiated lies from either the applicant, the
mortgage broker or both. The lender that ultimately approved the loan did so without
exercising due diligence to ensure that the applicant could afford the mortgage.
Additionally, many of these loans were packaged and sold to other lenders. Fannie Mae
and Freddie Mac may have bought some of these loans. Additionally, many of these loans
packages ended up in investors hands as Collateralized Debt Obligations (CDOs).
CDOs were previously viewed as relatively safe investments, since they were secured by
real property. However, with many of these properties now worth less than the loan
balance and record numbers of homeowners losing their homes to foreclosure, many
CDOs were subject to heavy losses that would be incurred by investors.
The fall of Bear Stearns was just the tip of the iceberg. Lehman Brothers filed the largest
bankruptcy in history due to massive losses and resulting shareholder panic. American
International Group (AIG) was effectively nationalized, with the federal government
taking an 80% stake in the firm to prevent collapse. Even the venerable Merrill Lynch
allowed a sale to Bank of America to prevent a short sale-fueled decline in its stock price.
With Morgan Stanley now being eyed by everyone from Barclays Bank to Wachovia, the
fallout from this crisis may finally be reaching rock bottom. Predictions of a great
recession may not be realized if the governments plan to form a new bailout entity
works. This could finally give financial institutions a buyer for their toxic loan
portfolios.
The root of all of these problems is the NINJA loan. The greed that caused most investors
and related companies to turn a blind eye to the potential risks put our entire financial
system at risk. All of this occurred because of the weakness of mortgage regulations that
allowed for these stated income loans to occur in the first place.
A brighter outlook can be found in North Carolina. North Carolina law places greater
restrictions on the exotic loan products that are likely to be defaulted on. With greater

consumer protections in place, the housing markets were unable to overheat as they had
in other areas. As such, many areas of North Carolina averted much of the housing slump.
Charlotte and Raleigh did not experience a rapid decline in housing prices, and many
areas still saw measurable growth in housing prices.
As long as financial institutions accept poorly documented loan applications and
investors still purchase the loan portfolios, there will always be a much higher risk to our
financial system. Dont feel bad for the firms that are in trouble. It is their fault, and the
NINJA loan is the root cause of their problems.
1. Proliferation of Exotic Mortgage Products: Exploding ARMs and interest only
mortgage products were only intended for a very small subset of mortgage
applicants. These included high income sales professionals or other applicants
expecting either a quick resale or an impending financial windfall. Most
applicants steered into these loans were a poor match for the products and could
never be expected to afford the payments on such loans beyond a year or two.
2. Relaxed Underwriting Standards: Lenders that approved mortgage applications
based on stated income did not properly verify the ability of the applicants to
reasonably afford the mortgage payments. Many lenders knew that the borrowers
would likely default, but they approved the loans anyways and quickly resold the
loans on the secondary mortgage market. Such loans were resold in packages that
were often grouped into special securities that investors could buy.
3. Ineffective Mortgage Controls: Brokers profiteered by steering applicants into
bad loan products that carried much higher commissions (yield spread premiums).
Many brokers crossed the line even further by committing fraud. Some lied on
loan applications or coached applicants on how to lie to improve acceptance of
their application. The fabled NINJA loan is a direct result of such fraud. Others
pressured applicants into signing mortgage documents that were for a different
loan product than was discussed. Investigations of fraud and convictions for
criminal activity were few, while fraudulent acts were widespread.
4. Secondary Mortgage Markets Enabled Risky Loans: Lenders could never
justify keeping risky loans on their books. Such a loan portfolio carried too much
risk and would ultimately cause their downfall. Instead, they packaged these
loans carefully so that the buyers would not fully understand the risky nature of
much of the loans included. Additionally, Fannie Mae and Freddie Mac purchased
many loans from lenders with the false expectation that reasonable care was taken
to ensure creditworthiness and reasonable repayment ability of the applicants.
5. Collateralized Debt Obligations (CDOs) Facilitated Sale of Junk Mortgages
to Unsuspecting Buyers: Some purchasers of CDOs fault the computer models
that were supposed to help reduce the risk of such securities. However, what they
failed to realize is that the whole purpose of such models was to hide bad
mortgage loans in with other investments so that the buyer was unaware of the
junk they were purchasing. They were simply looking to mask the risky loans so
they could be unloaded to unsuspecting buyers.
6. Loan to Value Limits Expanded: Lenders assumed that home values would
continue to rise at rates higher than they historically had risen. What they failed to

account for is that the housing market had expanded into a massive bubble, and
that it would soon burst. A conventional mortgage limits the loan to value limit to
80% of the purchase price. Other products such as FHA and other CRA backed
programs allowed for up to 100%. These were not the problem. The problem
arose from lenders allowing for a loan to value ratio of up to 120%. This
exacerbated the negative equity situation that many distressed homeowners
currently find themselves in. They cannot sell or refinance their mortgages
because they owe more than the home is worth.
7. Government Guarantees: The federal government guarantees loans purchased
by Fannie Mae and Freddie Mac in order to stimulate further lending activity.
This promise is what contributed to the rapid expansion of Fannie Mae and
Freddie Mac loan pools. As long as the loans were guaranteed, there was less
concern about higher rates of default. Accordingly, lenders took greater risks
knowing that these risks could be offloaded onto federal agencies and ultimately,
the taxpayer. Ironically, the same government interference that increased lending
also contributed to its hyperactivity and decline.
The financial crisis from 2007 to the present is considered by many economists to be the worst
financial crisis since the Great Depression of the 1930s. It was triggered by a liquidity shortfall in
the United States banking system, and has resulted in the collapse of large financial institutions,
the bailout of banks by national governments, and downturns in stock markets around the world.
In many areas, the housing market has also suffered, resulting in numerous evictions, foreclosures
and prolonged vacancies. It contributed to the failure of key businesses, declines in consumer
wealth estimated in the trillions of U.S. dollars, substantial financial commitments incurred by
governments, and a significant decline in economic activity.
Although there have been aftershocks, the financial crisis officially ended in 2008. Many causes
for the financial crisis have been suggested, with varying weight assigned by experts. Both
market-based and regulatory solutions have been implemented or are under consideration.
Overview
The collapse of the U.S. housing bubble, which peaked in 2006, caused the values of securities
tied to U.S. real estate pricing to plummet, damaging financial institutions globally. Questions
regarding bank solvency, declines in credit availability and damaged investor confidence had an
impact on global stock markets, where securities suffered large losses during late 2008 and early
2009. Economies worldwide slowed during this period, as credit tightened and international trade
declined. Critics argued that credit rating agencies and investors failed to accurately price the risk
involved with mortgage-related financial products, and that governments did not adjust their
regulatory practices to address 21st-century financial markets. Governments and central banks
responded with unprecedented fiscal stimulus, monetary policy expansion and institutional
bailouts.

Background
The immediate cause or trigger of the crisis was the bursting of the United States housing
bubble which peaked in approximately 20052006. Already-rising default rates on
"subprime" and adjustable rate mortgages (ARM) began to increase quickly thereafter. As

banks began to increasingly give out more loans to potential home owners, the housing
price also began to rise. In the optimistic terms the banks would encourage the home
owners to take on considerably high loans in the belief they would be able to pay it back
more quickly overlooking the interest rates. Once the interest rates began to rise in mid
2007 the housing price started to drop significantly in 2006 leading into 2007. In many
states like California refinancing became more difficult. As a result the number of
foreclosed homes began to rise as well.
Steadily decreasing interest rates backed by the U.S Federal Reserve from 1982 onward
and large inflows of foreign funds created easy credit conditions for a number of years
prior to the crisis, fueling a housing construction boom and encouraging debt-financed
consumption. The combination of easy credit and money inflow contributed to the United
States housing bubble. Loans of various types (e.g., mortgage, credit card, and auto) were
easy to obtain and consumers assumed an unprecedented debt load. As part of the
housing and credit booms, the number of financial agreements called mortgage-backed
securities (MBS) and collateralized debt obligations (CDO), which derived their value
from mortgage payments and housing prices, greatly increased. Such financial innovation
enabled institutions and investors around the world to invest in the U.S. housing market.
As housing prices declined, major global financial institutions that had borrowed and
invested heavily in subprime MBS reported significant losses. Falling prices also resulted
in homes worth less than the mortgage loan, providing a financial incentive to enter
foreclosure. The ongoing foreclosure epidemic that began in late 2006 in the U.S.
continues to drain wealth from consumers and erodes the financial strength of banking
institutions. Defaults and losses on other loan types also increased significantly as the
crisis expanded from the housing market to other parts of the economy. Total losses are
estimated in the trillions of U.S. dollars globally.
While the housing and credit bubbles built, a series of factors caused the financial system
to both expand and become increasingly fragile, a process called financialization. U. S.
Government policy from the 1970s onward has emphasized deregulation to encourage
business, which resulted in less oversight of activities and less disclosure of information
about new activities undertaken by banks and other evolving financial institutions. Thus,
policymakers did not immediately recognize the increasingly important role played by
financial institutions such as investment banks and hedge funds, also known as the
shadow banking system. Some experts believe these institutions had become as important
as commercial (depository) banks in providing credit to the U.S. economy, but they were
not subject to the same regulations. These institutions, as well as certain regulated banks,
had also assumed significant debt burdens while providing the loans described above and
did not have a financial cushion sufficient to absorb large loan defaults or MBS losses.
These losses impacted the ability of financial institutions to lend, slowing economic
activity. Concerns regarding the stability of key financial institutions drove central banks
to provide funds to encourage lending and restore faith in the commercial paper markets,
which are integral to funding business operations. Governments also bailed out key
financial institutions and implemented economic stimulus programs, assuming significant
additional financial commitments.

The U.S. Financial Crisis Inquiry Commission reported its findings in January 2011. It
concluded that "the crisis was avoidable and was caused by: Widespread failures in
financial regulation, including the Federal Reserves failure to stem the tide of toxic
mortgages; Dramatic breakdowns in corporate governance including too many financial
firms acting recklessly and taking on too much risk; An explosive mix of excessive
borrowing and risk by households and Wall Street that put the financial system on a
collision course with crisis; Key policy makers ill prepared for the crisis, lacking a full
understanding of the financial system they oversaw; and systemic breaches in
accountability and ethics at all levels.
Growth of the housing bubble
A graph showing the median and average sales prices of new homes sold in the United States between 1963
and 2008 (not adjusted for inflation)

Between 1997 and 2006, the price of the typical American house increased by 124%.
During the two decades ending in 2001, the national median home price ranged from 2.9
to 3.1 times median household income. This ratio rose to 4.0 in 2004, and 4.6 in 2006.
This housing bubble resulted in quite a few homeowners refinancing their homes at lower
interest rates, or financing consumer spending by taking out second mortgages secured by
the price appreciation.
In a Peabody Award winning program, NPR correspondents argued that a "Giant Pool of
Money" (represented by $70 trillion in worldwide fixed income investments) sought
higher yields than those offered by U.S. Treasury bonds early in the decade. This pool of
money had roughly doubled in size from 2000 to 2007, yet the supply of relatively safe,
income generating investments had not grown as fast. Investment banks on Wall Street
answered this demand with the MBS and CDO, which were assigned safe ratings by the
credit rating agencies. In effect, Wall Street connected this pool of money to the mortgage
market in the U.S., with enormous fees accruing to those throughout the mortgage supply
chain, from the mortgage broker selling the loans, to small banks that funded the brokers,
to the giant investment banks behind them. By approximately 2003, the supply of
mortgages originated at traditional lending standards had been exhausted. However,
continued strong demand for MBS and CDO began to drive down lending standards, as
long as mortgages could still be sold along the supply chain. Eventually, this speculative
bubble proved unsustainable.
The CDO in particular enabled financial institutions to obtain investor funds to finance
subprime and other lending, extending or increasing the housing bubble and generating
large fees. A CDO essentially places cash payments from multiple mortgages or other
debt obligations into a single pool, from which the cash is allocated to specific securities
in a priority sequence. Those securities obtaining cash first received investment-grade
ratings from rating agencies. Lower priority securities received cash thereafter, with
lower credit ratings but theoretically a higher rate of return on the amount invested.
By September 2008, average U.S. housing prices had declined by over 20% from their
mid-2006 peak. As prices declined, borrowers with adjustable-rate mortgages could not
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refinance to avoid the higher payments associated with rising interest rates and began to
default. During 2007, lenders began foreclosure proceedings on nearly 1.3 million
properties, a 79% increase over 2006. This increased to 2.3 million in 2008, an 81%
increase vs. 2007. By August 2008, 9.2% of all U.S. mortgages outstanding were either
delinquent or in foreclosure. By September 2009, this had risen to 14.4%.
Easy credit conditions
Lower interest rates encourage borrowing. From 2000 to 2003, the Federal Reserve
lowered the federal funds rate target from 6.5% to 1.0%.This was done to soften the
effects of the collapse of the dot-com bubble and of the September 2001 terrorist attacks,
and to combat the perceived risk of deflation.
U.S. current account or trade deficit

Additional downward pressure on interest rates was created by the USA's high and rising
current account (trade) deficit, which peaked along with the housing bubble in 2006. Ben
Bernanke explained how trade deficits required the U.S. to borrow money from abroad,
which bid up bond prices and lowered interest rates.
Bernanke explained that between 1996 and 2004, the USA current account deficit
increased by $650 billion, from 1.5% to 5.8% of GDP. Financing these deficits required
the USA to borrow large sums from abroad, much of it from countries running trade
surpluses, mainly the emerging economies in Asia and oil-exporting nations. The balance
of payments identity requires that a country (such as the USA) running a current account
deficit also have a capital account (investment) surplus of the same amount. Hence large
and growing amounts of foreign funds (capital) flowed into the USA to finance its
imports.
This created demand for various types of financial assets, raising the prices of those
assets while lowering interest rates. Foreign investors had these funds to lend, either
because they had very high personal savings rates (as high as 40% in China), or because
of high oil prices. Bernanke referred to this as a "saving glut."
A "flood" of funds (capital or liquidity) reached the USA financial markets. Foreign
governments supplied funds by purchasing USA Treasury bonds and thus avoided much
of the direct impact of the crisis. USA households, on the other hand, used funds
borrowed from foreigners to finance consumption or to bid up the prices of housing and
financial assets. Financial institutions invested foreign funds in mortgage-backed
securities.
The Fed then raised the Fed funds rate significantly between July 2004 and July 2006.
This contributed to an increase in 1-year and 5-year adjustable-rate mortgage (ARM)
rates, making ARM interest rate resets more expensive for homeowners. This may have
also contributed to the deflating of the housing bubble, as asset prices generally move
inversely to interest rates and it became riskier to speculate in housing. USA housing and
financial assets dramatically declined in value after the housing bubble burst.
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Weak and fraudulent underwriting practice

Testimony given to the Financial Crisis Inquiry Commission by Richard M. Bowen, III
on events during his tenure as Citi's Business Chief Underwriter for Correspondent
Lending in the Consumer Lending Group (where he was responsible for over 220
professional underwriters) suggests that by the final years of the US housing bubble
(20062007), the collapse of mortgage underwriting standards was endemic. His
testimony states that by 2006, 60% of mortgages purchased by Citi from some 1,600
mortgage companies were "defective" (were not underwritten to policy, or did not contain
all policy-required documents). This, despite the fact that each of these 1,600 originators
were contractually responsible (certified via representations and warrantees) that their
mortgage originations met Citi's standards. Moreover, during 2007, "defective mortgages
(from mortgage originators contractually bound to perform underwriting to Citi's
standards) increased... to over 80% of production".
In separate testimony to Financial Crisis Inquiry Commission, officers of Clayton
Holdingsthe largest residential loan due diligence and securitization surveillance
company in the United States and Europetestified that Clayton's review of over
900,000 mortgages issued from January 2006 to June 2007 revealed that scarcely 54% of
the loans met their originators underwriting standards. The analysis (conducted on behalf
of 23 investment and commercial banks, including 7 "Too Big To Fail" banks)
additionally showed that 28% of the sampled loans did not meet the minimal standards of
any issuer. Clayton's analysis further showed that 39% of these loans (i.e. those not
meeting any issuer's minimal underwriting standards) were subsequently securitized and
sold to investors.
Sub-prime lending
U.S. subprime lending expanded dramatically 2004-2006

The term subprime refers to the credit quality of particular borrowers, who have
weakened credit histories and a greater risk of loan default than prime borrowers. The
value of U.S. subprime mortgages was estimated at $1.3 trillion as of March 2007, with
over 7.5 million first-lien subprime mortgages outstanding.
In addition to easy credit conditions, there is evidence that both government and
competitive pressures contributed to an increase in the amount of subprime lending
during the years preceding the crisis. Major U.S. investment banks and government
sponsored enterprises like Fannie Mae played an important role in the expansion of
higher-risk lending.
Subprime mortgages remained below 10% of all mortgage originations until 2004, when
they spiked to nearly 20% and remained there through the 2005-2006 peak of the United
States housing bubble. A proximate event to this increase was the April 2004 decision by
the U.S. Securities and Exchange Commission (SEC) to relax the net capital rule, which
permitted the largest five investment banks to dramatically increase their financial
leverage and aggressively expand their issuance of mortgage-backed securities. This
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applied additional competitive pressure to Fannie Mae and Freddie Mac, which further
expanded their riskier lending. Subprime mortgage payment delinquency rates remained
in the 10-15% range from 1998 to 2006, then began to increase rapidly, rising to 25% by
early 2008.
Some, like American Enterprise Institute fellow Peter J. Wallison, believe the roots of the
crisis can be traced directly to sub-prime lending by Fannie Mae and Freddie Mac, which
are government sponsored entities. On September 30, 1999, The New York Times reported
that the Clinton Administration pushed for more lending to low and moderate income
borrowers, while the mortgage industry sought guarantees for sub-prime loans:
Fannie Mae, the nation's biggest underwriter of home mortgages, has been under
increasing pressure from the Clinton Administration to expand mortgage loans among
low and moderate income people and felt pressure from stock holders to maintain its
phenomenal growth in profits. In addition, banks, thrift institutions and mortgage
companies have been pressing Fannie Mae to help them make more loans to so-called
subprime borrowers... In moving, even tentatively, into this new area of lending, Fannie
Mae is taking on significantly more risk, which may not pose any difficulties during flush
economic times. But the government-subsidized corporation may run into trouble in an
economic downturn, prompting a government rescue similar to that of the savings and
loan industry in the 1980s.
A 2000 United States Department of the Treasury study of lending trends for 305 cities
from 1993 to 1998 showed that $467 billion of mortgage lending was made by
Community Reinvestment Act (CRA)-covered lenders into low and mid level income
(LMI) borrowers and neighborhoods, representing 10% of all US mortgage lending
during the period. The majority of these were prime loans. Sub-prime loans made by
CRA-covered institutions constituted a 3% market share of LMI loans in 1998.
Nevertheless, only 25% of all sub-prime lending occurred at CRA-covered institutions,
and a full 50% of sub-prime loans originated at institutions exempt from CRA. For at
least one mortgage lender,CRA loans were the more "vulnerable during the downturn, to
the detriment of both borrowers and lenders. For example, lending done under
Community Reinvestment Act criteria, according to a quarterly report in October of 2008,
constituted only 7% of the total mortgage lending by the Bank of America, but
constituted 29% of its losses on mortgages."
Others have pointed out that there were not enough of these loans made to cause a crisis
of this magnitude. In an article in Portfolio Magazine, Michael Lewis spoke with one
trader who noted that "There werent enough Americans with [bad] credit taking out [bad
loans] to satisfy investors appetite for the end product." Essentially, investment banks
and hedge funds used financial innovation to enable large wagers to be made, far beyond
the actual value of the underlying mortgage loans, using derivatives called credit default
swaps, CDO and synthetic CDO. As long as derivative buyers could be matched with
sellers, the theoretical amount that could be wagered was infinite. "They were creating
[synthetic loans] out of whole cloth. One hundred times over! Thats why the losses are
so much greater than the loans."

Economist Paul Krugman argued in January 2010 that the simultaneous growth of the
residential and commercial real estate pricing bubbles undermines the case made by those
who argue that Fannie Mae, Freddie Mac, CRA or predatory lending were primary causes
of the crisis. In other words, bubbles in both markets developed even though only the
residential market was affected by these potential causes.
Predatory lending
Predatory lending refers to the practice of unscrupulous lenders, enticing borrowers to
enter into "unsafe" or "unsound" secured loans for inappropriate purposes. A classic baitand-switch method was used by Countrywide Financial, advertising low interest rates for
home refinancing. Such loans were written into extensively detailed contracts, and
swapped for more expensive loan products on the day of closing. Whereas the
advertisement might state that 1% or 1.5% interest would be charged, the consumer
would be put into an adjustable rate mortgage (ARM) in which the interest charged
would be greater than the amount of interest paid. This created negative amortization,
which the credit consumer might not notice until long after the loan transaction had been
consummated.
Countrywide, sued by California Attorney General Jerry Brown for "unfair business
practices" and "false advertising" was making high cost mortgages "to homeowners with
weak credit, adjustable rate mortgages (ARMs) that allowed homeowners to make
interest-only payments". When housing prices decreased, homeowners in ARMs then had
little incentive to pay their monthly payments, since their home equity had disappeared.
This caused Countrywide's financial condition to deteriorate, ultimately resulting in a
decision by the Office of Thrift Supervision to seize the lender.
Former employees from Ameriquest, which was United States's leading wholesale lender,
described a system in which they were pushed to falsify mortgage documents and then
sell the mortgages to Wall Street banks eager to make fast profits. There is growing
evidence that such mortgage frauds may be a cause of the crisis.
Deregulation
Critics such as economist Paul Krugman and U.S. Treasury Secretary Timothy Geithner
have argued that the regulatory framework did not keep pace with financial innovation,
such as the increasing importance of the shadow banking system, derivatives and offbalance sheet financing. In other cases, laws were changed or enforcement weakened in
parts of the financial system. Key examples include:

Jimmy Carter's Depository Institutions Deregulation and Monetary Control Act of

1980 (DIDMCA) phased out a number of restrictions on banks' financial
practices, broadened their lending powers, and raised the deposit insurance limit
from $40,000 to $100,000 (raising the problem of moral hazard). Banks rushed
into real estate lending, speculative lending, and other ventures just as the
economy soured.

In October 1982, U.S. President Ronald Reagan signed into Law the GarnSt.
Germain Depository Institutions Act, which provided for adjustable-rate mortgage
loans, began the process of banking deregulation, and contributed to the savings
and loan crisis of the late 1980s/early 1990s.
In November 1999, U.S. President Bill Clinton signed into Law the GrammLeach-Bliley Act, which repealed part of the GlassSteagall Act of 1933. This
repeal has been criticized for reducing the separation between commercial banks
(which traditionally had fiscally conservative policies) and investment banks
(which had a more risk-taking culture).
In 2004, the U.S. Securities and Exchange Commission relaxed the net capital
rule, which enabled investment banks to substantially increase the level of debt
they were taking on, fueling the growth in mortgage-backed securities supporting
subprime mortgages. The SEC has conceded that self-regulation of investment
banks contributed to the crisis.
Financial institutions in the shadow banking system are not subject to the same
regulation as depository banks, allowing them to assume additional debt
obligations relative to their financial cushion or capital base. This was the case
despite the Long-Term Capital Management debacle in 1998, where a highlyleveraged shadow institution failed with systemic implications.
Regulators and accounting standard-setters allowed depository banks such as
Citigroup to move significant amounts of assets and liabilities off-balance sheet
into complex legal entities called structured investment vehicles, masking the
weakness of the capital base of the firm or degree of leverage or risk taken. One
news agency estimated that the top four U.S. banks will have to return between
$500 billion and $1 trillion to their balance sheets during 2009. This increased
uncertainty during the crisis regarding the financial position of the major banks.
Off-balance sheet entities were also used by Enron as part of the scandal that
brought down that company in 2001.
As early as 1997, Federal Reserve Chairman Alan Greenspan fought to keep the
derivatives market unregulated. With the advice of the President's Working Group
on Financial Markets, the U.S. Congress and President allowed the self-regulation
of the over-the-counter derivatives market when they enacted the Commodity
Futures Modernization Act of 2000. Derivatives such as credit default swaps
(CDS) can be used to hedge or speculate against particular credit risks. The
volume of CDS outstanding increased 100-fold from 1998 to 2008, with estimates
of the debt covered by CDS contracts, as of November 2008, ranging from US$33
to $47 trillion. Total over-the-counter (OTC) derivative notional value rose to
$683 trillion by June 2008. Warren Buffett famously referred to derivatives as
"financial weapons of mass destruction" in early 2003.

Increased debt burden or over-leveraging

leverage ratios of investment banks increased significantly 2003-2007

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U.S. households and financial institutions became increasingly indebted or overleveraged

during the years preceding the crisis. This increased their vulnerability to the collapse of
the housing bubble and worsened the ensuing economic downturn. Key statistics include:

Free cash used by consumers from home equity extraction doubled from
$627 billion in 2001 to $1,428 billion in 2005 as the housing bubble built, a total
of nearly $5 trillion dollars over the period, contributing to economic growth
worldwide. U.S. home mortgage debt relative to GDP increased from an average
of 46% during the 1990s to 73% during 2008, reaching $10.5 trillion.

USA household debt as a percentage of annual disposable personal income was

127% at the end of 2007, versus 77% in 1990.

In 1981, U.S. private debt was 123% of GDP; by the third quarter of 2008, it was
290%.

From 2004-07, the top five U.S. investment banks each significantly increased
their financial leverage (see diagram), which increased their vulnerability to a
financial shock. These five institutions reported over $4.1 trillion in debt for fiscal
year 2007, about 30% of USA nominal GDP for 2007. Lehman Brothers was
liquidated, Bear Stearns and Merrill Lynch were sold at fire-sale prices, and
Goldman Sachs and Morgan Stanley became commercial banks, subjecting
themselves to more stringent regulation. With the exception of Lehman, these
companies required or received government support.

Fannie Mae and Freddie Mac, two U.S. Government sponsored enterprises,
owned or guaranteed nearly $5 trillion in mortgage obligations at the time they
were placed into conservatorship by the U.S. government in September 2008.

These seven entities were highly leveraged and had $9 trillion in debt or guarantee
obligations; yet they were not subject to the same regulation as depository banks.
Financial innovation and complexity
IMF Diagram of CDO and RMBS

The term financial innovation refers to the ongoing development of financial products
designed to achieve particular client objectives, such as offsetting a particular risk
exposure (such as the default of a borrower) or to assist with obtaining financing.
Examples pertinent to this crisis included: the adjustable-rate mortgage; the bundling of
subprime mortgages into mortgage-backed securities (MBS) or collateralized debt
obligations (CDO) for sale to investors, a type of securitization; and a form of credit
insurance called credit default swaps (CDS). The usage of these products expanded
dramatically in the years leading up to the crisis. These products vary in complexity and
the ease with which they can be valued on the books of financial institutions.

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CDO issuance grew from an estimated $20 billion in Q1 2004 to its peak of over $180
billion by Q1 2007, then declined back under $20 billion by Q1 2008. Further, the credit
quality of CDO's declined from 20002007, as the level of subprime and other non-prime
mortgage debt increased from 5% to 36% of CDO assets. As described in the section on
subprime lending, the CDS and portfolio of CDS called synthetic CDO enabled a
theoretically infinite amount to be wagered on the finite value of housing loans
outstanding, provided that buyers and sellers of the derivatives could be found. For
example, selling a CDS to insure a CDO ended up giving the seller the same risk as if
they owned the CDO, when those CDO's became worthless.
Martin Wolf wrote in June 2009 that certain financial innovations enabled firms to
circumvent regulations, such as off-balance sheet financing that affects the leverage or
capital cushion reported by major banks, stating: "...an enormous part of what banks did
in the early part of this decade the off-balance-sheet vehicles, the derivatives and the
'shadow banking system' itself was to find a way round regulation."
Incorrect pricing of risk
The pricing of risk refers to the incremental compensation required by investors for
taking on additional risk, which may be measured by interest rates or fees. For a variety
of reasons, market participants did not accurately measure the risk inherent with financial
innovation such as MBS and CDO's or understand its impact on the overall stability of
the financial system. For example, the pricing model for CDOs clearly did not reflect the
level of risk they introduced into the system. Banks estimated that $450bn of CDO were
sold between "late 2005 to the middle of 2007"; among the $102bn of those that had been
liquidated, JPMorgan estimated that the average recovery rate for "high quality" CDOs
was approximately 32 cents on the dollar, while the recovery rate for mezzanine CDO
was approximately five cents for every dollar.
Another example..... relates to AIG, which insured obligations of various financial
institutions through the usage of credit default swaps. The basic CDS transaction
involved AIG receiving a premium in exchange for a promise to pay money to party A in
the event party B defaulted. However, AIG did not have the financial strength to support
its many CDS commitments as the crisis progressed and was taken over by the
government in September 2008. U.S. taxpayers provided over $180 billion in government
support to AIG during 2008 and early 2009, through which the money flowed to various
counterparties to CDS transactions, including many large global financial institutions.
The limitations of a widely-used financial model also were not properly understood. This
formula assumed that the price of CDS was correlated with and could predict the correct
price of mortgage backed securities. Because it was highly tractable, it rapidly came to be
used by a huge percentage of CDO and CDS investors, issuers, and rating agencies.
According to one wired.com article:
Then the model fell apart. Cracks started appearing early on, when financial markets
began behaving in ways that users of Li's formula hadn't expected. The cracks became

12

full-fledged canyons in 2008when ruptures in the financial system's foundation

swallowed up trillions of dollars and put the survival of the global banking system in
serious peril... Li's Gaussian copula formula will go down in history as instrumental in
causing the unfathomable losses that brought the world financial system to its knees.[100]
As financial assets became more and more complex, and harder and harder to value,
investors were reassured by the fact that both the international bond rating agencies and
bank regulators, who came to rely on them, accepted as valid some complex
mathematical models which theoretically showed the risks were much smaller than they
actually proved to be. George Soros commented that "The super-boom got out of hand
when the new products became so complicated that the authorities could no longer
calculate the risks and started relying on the risk management methods of the banks
themselves. Similarly, the rating agencies relied on the information provided by the
originators of synthetic products. It was a shocking abdication of responsibility." [102]
Moreover, a conflict of interest between professional investment managers and their
institutional clients, combined with a global glut in investment capital, led to bad
investments by asset managers in over-priced credit assets. Professional investment
managers generally are compensated based on the volume of client assets under
management. There is, therefore, an incentive for asset managers to expand their assets
under management in order to maximize their compensation. As the glut in global
investment capital caused the yields on credit assets to decline, asset managers were
faced with the choice of either investing in assets where returns did not reflect true credit
risk or returning funds to clients. Many asset managers chose to continue to invest client
funds in over-priced (under-yielding) investments, to the detriment of their clients, in
order to maintain their assets under management. This choice was supported by a
plausible deniability of the risks associated with subprime-based credit assets because
the loss experience with early vintages of subprime loans was so low.
Despite the dominance of the above formula, there are documented attempts of the
financial industry, occurring before the crisis, to address the formula limitations,
specifically the lack of dependence dynamics and the poor representation of extreme
events. The volume "Credit Correlation: Life After Copulas", published in 2007 by World
Scientific, summarizes a 2006 conference held by Merrill Lynch in London where several
practitioners attempted to propose models rectifying some of the copula limitations. See
also the article by Donnelly and Embrechts and the book by Brigo, Pallavicini and
Torresetti, that reports relevant warnings and research on CDOs appeared in 2006.
Boom and collapse of the shadow banking system
In a June 2008 speech, President and CEO of the New York Federal Reserve Bank
Timothy Geithner who in 2009 became Secretary of the United States Treasury
placed significant blame for the freezing of credit markets on a "run" on the entities in the
"parallel" banking system, also called the shadow banking system. These entities became
critical to the credit markets underpinning the financial system, but were not subject to
the same regulatory controls. Further, these entities were vulnerable because of maturity

13

mismatch, meaning that they borrowed short-term in liquid markets to purchase longterm, illiquid and risky assets. This meant that disruptions in credit markets would make
them subject to rapid deleveraging, selling their long-term assets at depressed prices. He
described the significance of these entities:
In early 2007, asset-backed commercial paper conduits, in structured investment vehicles,
in auction-rate preferred securities, tender option bonds and variable rate demand notes,
had a combined asset size of roughly $2.2 trillion. Assets financed overnight in triparty
repo grew to $2.5 trillion. Assets held in hedge funds grew to roughly $1.8 trillion. The
combined balance sheets of the then five major investment banks totaled $4 trillion. In
comparison, the total assets of the top five bank holding companies in the United States at
that point were just over $6 trillion, and total assets of the entire banking system were
about $10 trillion. The combined effect of these factors was a financial system vulnerable
to self-reinforcing asset price and credit cycles.
Paul Krugman, laureate of the Nobel Prize in Economics, described the run on the
shadow banking system as the "core of what happened" to cause the crisis. He referred to
this lack of controls as "malign neglect" and argued that regulation should have been
imposed on all banking-like activity.
The securitization markets supported by the shadow banking system started to close
down in the spring of 2007 and nearly shut-down in the fall of 2008. More than a third of
the private credit markets thus became unavailable as a source of funds. According to the
Brookings Institution, the traditional banking system does not have the capital to close
this gap as of June 2009: "It would take a number of years of strong profits to generate
sufficient capital to support that additional lending volume." The authors also indicate
that some forms of securitization are "likely to vanish forever, having been an artifact of
excessively loose credit conditions."
Economist Mark Zandi testified to the Financial Crisis Inquiry Commission in January
2010: "The securitization markets also remain impaired, as investors anticipate more loan
losses. Investors are also uncertain about coming legal and accounting rule changes and
regulatory reforms. Private bond issuance of residential and commercial mortgagebacked securities, asset-backed securities, and CDOs peaked in 2006 at close to $2
trillion...In 2009, private issuance was less than $150 billion, and almost all of it was
asset-backed issuance supported by the Federal Reserve's TALF program to aid credit
card, auto and small-business lenders. Issuance of residential and commercial mortgagebacked securities and CDOs remains dormant."
Commodities boom
Rapid increases in a number of commodity prices followed the collapse in the housing
bubble. The price of oil nearly tripled from $50 to $147 from early 2007 to 2008, before
plunging as the financial crisis began to take hold in late 2008. Experts debate the causes,
with some attributing it to speculative flow of money from housing and other investments
into commodities, some to monetary policy, and some to the increasing feeling of raw

14

materials scarcity in a fast growing world, leading to long positions taken on those
markets, such as Chinese increasing presence in Africa. An increase in oil prices tends to
divert a larger share of consumer spending into gasoline, which creates downward
pressure on economic growth in oil importing countries, as wealth flows to oil-producing
states. A pattern of spiking instability in the price of oil over the decade leading up to the
price high of 2008 has been recently identified. The destabilizing effects of this price
variance has been proposed as a contributory factor in the financial crisis.
In testimony before the Senate Committee on Commerce, Science, and Transportation on
June 3, 2008, former director of the CFTC Division of Trading & Markets (responsible
for enforcement) Michael Greenberger specifically named the Atlanta-based
IntercontinentalExchange, founded by Goldman Sachs, Morgan Stanley and BP as
playing a key role in speculative run-up of oil futures prices traded off the regulated
futures exchanges in London and New York. However, the IntercontinentalExchange
(ICE) had been regulated by both European and US authorities since its purchase of the
International Petroleum Exchange in 2001. Mr Greenberger was later corrected on this
matter.
Copper prices increased at the same time as the oil prices. Copper traded at about $2,500
per tonne from 1990 until 1999, when it fell to about $1,600. The price slump lasted until
2004 which saw a price surge that had copper reaching $7,040 per tonne in 2008.
Nickel prices boomed in the late 1990s, then the price of nickel imploded from around
$51,000 /36,700 per metric ton in May 2007 to about $11,550/8,300 per metric ton in
January 2009. Prices were only just starting to recover as of January 2010, but most of
Australia's nickel mines had gone bankrupt by then. As the price for high grade nickel
sulphate ore recovered in 2010, so did the Australian nickel mining industry.
Coincidentally with these price fluctuations, long-only commodity index funds became
popular by one estimate investment increased from $90 billion in 2006 to $200 billion
at the end of 2007, while commodity prices increased 71% which raised concern as to
whether these index funds caused the commodity bubble. The empirical research has
been mixed.
Systemic crisis
Another analysis, different from the mainstream explanation, is that the financial crisis is
merely a symptom of another, deeper crisis, which is a systemic crisis of capitalism itself.
According to Samir Amin, an Egyptian Marxist economist, the constant decrease in GDP
growth rates in Western countries since the early 1970s created a growing surplus of
capital which did not have sufficient profitable investment outlets in the real economy.
The alternative was to place this surplus into the financial market, which became more
profitable than capital investment, especially with subsequent deregulation. According to
Samir Amin, this phenomenon has led to recurrent financial bubbles (such as the internet
bubble).

15

John Bellamy Foster, a political economy analyst and editor of the Monthly Review,
believes that the decrease in GDP growth rates since the early 1970s is due to increasing
market saturation.
John C. Bogle wrote during 2005 that a series of unresolved challenges face capitalism
that have contributed to past financial crises and have not been sufficiently addressed:
Corporate America went astray largely because the power of managers went virtually
unchecked by our gatekeepers for far too long...They failed to 'keep an eye on these
geniuses' to whom they had entrusted the responsibility of the management of America's
great corporations.
He cites particular issues, including:

"Manager's capitalism" which he argues has replaced "owner's capitalism,"

meaning management runs the firm for its benefit rather than for the shareholders,
a variation on the principal-agent problem;
Burgeoning executive compensation;
Managed earnings, mainly a focus on share price rather than the creation of
genuine value; and
The failure of gatekeepers, including auditors, boards of directors, Wall Street
analysts, and career politicians.

An analysis conducted by Mark Roeder, a former executive at the Swiss-based UBS

Bank, suggested that large scale momentum, or The Big Mo "played a pivotal role" in the
2008-09 global financial crisis. Roeder suggested that "recent technological advances,
such as computer-driven trading programs, together with the increasingly interconnected
nature of markets, has magnified the momentum effect. This has made the financial
sector inherently unstable.
Robert Reich has attributed the current economic downturn to the stagnation of wages in
the United States, particularly those of the hourly workers who comprise 80% of the
workforce. His claim is that this stagnation forced the population to borrow in order to
meet the cost of living.
Role of economic forecasting
The financial crisis was not widely predicted by mainstream economists, who instead
spoke of The Great Moderation. A number of heterodox economists predicted the crisis,
with varying arguments. Dirk Bezemer in his research credits (with supporting argument
and estimates of timing) 12 economists with predicting the crisis: Dean Baker (US),
Wynne Godley (UK), Fred Harrison (UK), Michael Hudson (US), Eric Janszen (US),
Steve Keen (Australia), Jakob Brchner Madsen & Jens Kjaer Srensen (Denmark), Kurt
Richebcher (US), Nouriel Roubini (US), Peter Schiff (US), and Robert Shiller (US).
Examples of other experts who gave indications of a financial crisis have also been given.

16

A cover story in BusinessWeek magazine claims that economists mostly failed to predict
the worst international economic crisis since the Great Depression of 1930s. The Wharton
School of the University of Pennsylvania's online business journal examines why
economists failed to predict a major global financial crisis. Popular articles published in
the mass media have led the general public to believe that the majority of economists
have failed in their obligation to predict the financial crisis. For example, an article in the
New York Times informs that economist Nouriel Roubini warned of such crisis as early
as September 2006, and the article goes on to state that the profession of economics is
bad at predicting recessions. According to The Guardian, Roubini was ridiculed for
predicting a collapse of the housing market and worldwide recession, while The New
York Times labelled him "Dr. Doom".
Within mainstream financial economics, most believe that financial crises are simply
unpredictable, following Eugene Fama's efficient-market hypothesis and the related
random-walk hypothesis, which state respectively that markets contain all information
about possible future movements, and that the movement of financial prices are random
and unpredictable.
Lebanese-American trader and financial risk engineer Nassim Nicholas Taleb, author of
the 2007 book The Black Swan, spent years warning 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 their reliance on bad models, and framed the
problem as part of "robustness and fragility".He also reacted against the cold of the
establishment by making a big financial bet on banking stocks and making a fortune from
the crisis ("They didn't listen, so I took their money") . According to David Brooks from
the New York Times, "Taleb not only has an explanation for whats happening, he saw it
coming." .
Financial markets impacts
Impacts on financial institutions
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.
These losses are expected to top $2.8 trillion from 2007-10. U.S. banks losses were
forecast to hit $1 trillion and European bank losses will reach $1.6 trillion. The IMF
estimated that U.S. banks were about 60% through their losses, but British and eurozone
banks only 40%.
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 (having failed to
find a private sector buyer) relented, and the bank was taken into public hands. Northern

17

Rock's problems proved to be an early indication of the troubles that would soon befall
other banks and financial institutions.
Initially the companies affected were those directly involved in home construction and
mortgage lending such as Northern Rock and Countrywide Financial, as they could no
longer obtain financing through the credit markets. Over 100 mortgage lenders went
bankrupt during 2007 and 2008. Concerns that investment bank Bear Stearns would
collapse in March 2008 resulted in its fire-sale to JP Morgan Chase. The financial
institution crisis hit its peak in September and October 2008. Several major institutions
either failed, were acquired under duress, or were subject to government takeover. These
included Lehman Brothers, Merrill Lynch, Fannie Mae, Freddie Mac, Washington
Mutual, Wachovia, and AIG.
Credit markets and the shadow banking system
During September 2008, the crisis hit its most critical stage. There was the equivalent of a
bank run on the money market mutual funds, which frequently invest in commercial
paper issued by corporations to fund their operations and payrolls. Withdrawal from
money markets were $144.5 billion during one week, versus $7.1 billion the week prior.
This interrupted the ability of corporations to rollover (replace) their short-term debt. The
U.S. government responded by extending insurance for money market accounts
analogous to bank deposit insurance via a temporary guarantee and with Federal Reserve
programs to purchase commercial paper. 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, reaching a record 4.65% on October 10,
2008.
In a dramatic meeting on September 18, 2008, Treasury Secretary Henry Paulson and Fed
Chairman Ben Bernanke met with key legislators to propose a $700 billion emergency
bailout. Bernanke reportedly told them: "If we don't do this, we may not have an
economy on Monday." The Emergency Economic Stabilization Act, which implemented
the Troubled Asset Relief Program (TARP), was signed into law on October 3, 2008.
Economist Paul Krugman and U.S. Treasury Secretary Timothy Geithner explain the
credit crisis via the implosion of the shadow banking system, which had grown to nearly
equal the importance of the traditional commercial banking sector as described above.
Without the ability to obtain investor funds in exchange for most types of mortgagebacked securities or asset-backed commercial paper, investment banks and other entities
in the shadow banking system could not provide funds to mortgage firms and other
corporations.
This meant that nearly one-third of the U.S. lending mechanism was frozen and
continued to be frozen into June 2009. According to the Brookings Institution, the
traditional banking system does not have the capital to close this gap as of June 2009: "It
would take a number of years of strong profits to generate sufficient capital to support
that additional lending volume." The authors also indicate that some forms of

18

securitization are "likely to vanish forever, having been an artifact of excessively loose
credit conditions." While traditional banks have raised their lending standards, it was the
collapse of the shadow banking system that is the primary cause of the reduction in funds
available for borrowing.
Wealth effects
there is a direct relationship between declines in wealth, and declines in consumption and
business investment, which along with government spending represent the economic
engine. Between June 2007 and November 2008, Americans lost an estimated average of
more than a quarter of their collective net worth . By early November 2008, a broad U.S.
stock index the S&P 500, was down 45% from its 2007 high. Housing prices had dropped
20% from their 2006 peak, with futures markets signaling a 30-35% potential drop. Total
home equity in the United States, which was valued at $13 trillion at its peak in 2006, had
dropped to $8.8 trillion by mid-2008 and was still falling in late 2008. Total retirement
assets, Americans' second-largest household asset, dropped by 22%, from $10.3 trillion in
2006 to $8 trillion in mid-2008. During the same period, savings and investment assets
(apart from retirement savings) lost $1.2 trillion and pension assets lost $1.3 trillion.
Taken together, these losses total a staggering $8.3 trillion. Since peaking in the second
quarter of 2007, household wealth is down $14 trillion.
Further, U.S. homeowners had extracted significant equity in their homes in the years
leading up to the crisis, which they could no longer do once housing prices collapsed.
Free cash used by consumers from home equity extraction doubled from $627 billion in
2001 to $1,428 billion in 2005 as the housing bubble built, a total of nearly $5 trillion
over the period. U.S. home mortgage debt relative to GDP increased from an average of
46% during the 1990s to 73% during 2008, reaching $10.5 trillion.
To offset this decline in consumption and lending capacity, the U.S. government and U.S.
Federal Reserve have committed $13.9 trillion, of which $6.8 trillion has been invested or
spent, as of June 2009. In effect, the Fed has gone from being the "lender of last resort" to
the "lender of only resort" for a significant portion of the economy. In some cases the Fed
can now be considered the "buyer of last resort."
Economist Dean Baker explained the reduction in the availability of credit this way:
Yes, consumers and businesses can't get credit as easily as they could a year ago. There is
a really good reason for tighter credit. Tens of millions of homeowners who had
substantial equity in their homes two years ago have little or nothing today. Businesses
are facing the worst downturn since the Great Depression. This matters for credit
decisions. A homeowner with equity in her home is very unlikely to default on a car loan
or credit card debt. They will draw on this equity rather than lose their car and/or have a
default placed on their credit record. On the other hand, a homeowner who has no equity
is a serious default risk. In the case of businesses, their creditworthiness depends on their
future profits. Profit prospects look much worse in November 2008 than they did in
November 2007 (of course, to clear-eyed analysts, they didn't look too good a year ago

19

either). While many banks are obviously at the brink, consumers and businesses would be
facing a much harder time getting credit right now even if the financial system were rock
solid. The problem with the economy is the loss of close to $6 trillion in housing wealth
and an even larger amount of stock wealth. Economists, economic policy makers and
economic reporters virtually all missed the housing bubble on the way up. If they still
can't notice its impact as the collapse of the bubble throws into the worst recession in the
post-war era, then they are in the wrong profession.
At the heart of the portfolios of many of these institutions were investments whose assets
had been derived from bundled home mortgages. Exposure to these mortgage-backed
securities, or to the credit derivatives used to insure them against failure, caused the
collapse or takeover of several key firms such as Lehman Brothers, AIG, Merrill Lynch,
and HBOS.
European contagion
The crisis rapidly developed and spread into a global economic shock, resulting in a
number of European bank failures, declines in various stock indexes, and large reductions
in the market value of equities and commodities.
Both MBS and CDO were purchased by corporate and institutional investors globally.
Derivatives such as credit default swaps also increased the linkage between large
financial institutions. Moreover, the de-leveraging of financial institutions, as assets were
sold to pay back obligations that could not be refinanced in frozen credit markets, further
accelerated the solvency crisis and caused a decrease in international trade.
World political leaders, national ministers of finance and central bank directors
coordinated their efforts to reduce fears, but the crisis continued. At the end of October
2008 a currency crisis developed, with investors transferring vast capital resources into
stronger currencies such as the yen, the dollar and the Swiss franc, leading many
emergent economies to seek aid from the International Monetary Fund.
Global effects
A number of commentators have suggested that if the liquidity crisis continues, there
could be an extended recession or worse. The continuing development of the crisis has
prompted in some quarters fears of a global economic collapse although there are now
many cautiously optimistic forecasters in addition to some prominent sources who remain
negative. The financial crisis is likely to yield the biggest banking shakeout since the
savings-and-loan meltdown. Investment bank UBS stated on October 6 that 2008 would
see a clear global recession, with recovery unlikely for at least two years. Three days later
UBS economists announced that the "beginning of the end" of the crisis had begun, with
the world starting to make the necessary actions to fix the crisis: capital injection by
governments; injection made systemically; interest rate cuts to help borrowers. The
United Kingdom had started systemic injection, and the world's central banks were now
cutting interest rates. UBS emphasized the United States needed to implement systemic

20

injection. UBS further emphasized that this fixes only the financial crisis, but that in
economic terms "the worst is still to come". UBS quantified their expected recession
durations on October 16: the Eurozone's would last two quarters, the United States' would
last three quarters, and the United Kingdom's would last four quarters. The economic
crisis in Iceland involved all three of the country's major banks. Relative to the size of its
economy, Icelands banking collapse is the largest suffered by any country in economic
history.
At the end of October UBS revised its outlook downwards: the forthcoming recession
would be the worst since the early 1980s recession with negative 2009 growth for the
U.S., Eurozone, UK; very limited recovery in 2010; but not as bad as the Great
Depression.
The Brookings Institution reported in June 2009 that U.S. consumption accounted for
more than a third of the growth in global consumption between 2000 and 2007. "The US
economy has been spending too much and borrowing too much for years and the rest of
the world depended on the U.S. consumer as a source of global demand." With a
recession in the U.S. and the increased savings rate of U.S. consumers, declines in growth
elsewhere have been dramatic. For the first quarter of 2009, the annualized rate of decline
in GDP was 14.4% in Germany, 15.2% in Japan, 7.4% in the UK, 18% in Latvia, 9.8% in
the Euro area and 21.5% for Mexico.
Some developing countries that had seen strong economic growth saw significant
slowdowns. For example, growth forecasts in Cambodia show a fall from more than 10%
in 2007 to close to zero in 2009, and Kenya may achieve only 3-4% growth in 2009,
down from 7% in 2007. According to the research by the Overseas Development
Institute, reductions in growth can be attributed to falls in trade, commodity prices,
investment and remittances sent from migrant workers (which reached a record
$251 billion in 2007, but have fallen in many countries since). This has stark implications
and has led to a dramatic rise in the number of households living below the poverty line,
be it 300,000 in Bangladesh or 230,000 in Ghana.
The World Bank reported in February 2009 that in the Arab World, was far less severely
affected by the credit crunch. With generally good balance of payments positions coming
into the crisis or with alternative sources of financing for their large current account
deficits, such as remittances, Foreign Direct Investment (FDI) or foreign aid, Arab
countries were able to avoid going to the market in the latter part of 2008. This group is
in the best position to absorb the economic shocks. They entered the crisis in
exceptionally strong positions. This gives them a significant cushion against the global
downturn. The greatest impact of the global economic crisis will come in the form of
lower oil prices, which remains the single most important determinant of economic
performance. Steadily declining oil prices would force them to draw down reserves and
cut down on investments. Significantly lower oil prices could cause a reversal of
economic performance as has been the case in past oil shocks. Initial impact will be seen
on public finances and employment for foreign workers.

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Responses to financial crisis

Emergency and short-term responses
The U.S. Federal Reserve and central banks around the world have taken steps to expand
money supplies to avoid the risk of a deflationary spiral, in which lower wages and
higher unemployment lead to a self-reinforcing decline in global consumption. In
addition, governments have enacted large fiscal stimulus packages, by borrowing and
spending to offset the reduction in private sector demand caused by the crisis. The U.S.
executed two stimulus packages, totaling nearly $1 trillion during 2008 and 2009.
This credit freeze brought the global financial system to the brink of collapse. The
response of the U.S. Federal Reserve, the European Central Bank, and other central banks
was immediate and dramatic. During the last quarter of 2008, these central banks
purchased US$2.5 trillion of government debt and troubled private assets from banks.
This was the largest liquidity injection into the credit market, and the largest monetary
policy action, in world history. The governments of European nations and the USA also
raised the capital of their national banking systems by $1.5 trillion, by purchasing newly
issued preferred stock in their major banks. In October 2010, Nobel laureate Joseph
Stiglitz explained how the U.S. Federal Reserve was implementing another monetary
policy creating currency as a method to combat the liquidity trap. By creating
$600,000,000,000 and inserting this directly into banks the Federal Reserve intended to
spur banks to finance more domestic loans and refinance mortgages. However, banks
instead were spending the money in more profitable areas by investing internationally in
emerging markets. Banks were also investing in foreign currencies which Stiglitz and
others point out may lead to currency wars while China redirects its currency holdings
away from the United States.
Governments have also bailed out a variety of firms as discussed above, incurring large
financial obligations. To date, various U.S. government agencies have committed or spent
trillions of dollars in loans, asset purchases, guarantees, and direct spending. For a
summary of U.S. government financial commitments and investments related to the
crisis, see CNN - Bailout Scorecard. Significant controversy has accompanied the bailout,
leading to the development of a variety of "decision making frameworks", to help balance
competing policy interests during times of financial crisis.
Regulatory proposals and long-term responses
United States President Barack Obama and key advisers introduced a series of regulatory
proposals in June 2009. The proposals address consumer protection, executive pay, bank financial
cushions or capital requirements, expanded regulation of the shadow banking system and
derivatives, and enhanced authority for the Federal Reserve to safely wind-down systemically
important institutions, among others. In January 2010, Obama proposed additional regulations
limiting the ability of banks to engage in proprietary trading. The proposals were dubbed "The
Volcker Rule", in recognition of Paul Volcker, who has publicly argued for the proposed changes.

22

The U.S. Senate passed a regulatory reform bill in May 2010, following the House which
passed a bill in December 2009. These bills must now be reconciled. The New York Times
provided a comparative summary of the features of the two bills, which address to
varying extent the principles enumerated by the Obama administration. For instance, the
Volcker Rule against proprietary trading is not part of the legislation, though in the Senate
bill regulators have the discretion but not the obligation to prohibit these trades.
A variety of other regulatory changes have been proposed by economists, politicians, journalists,
and business leaders to minimize the impact of the current crisis and prevent recurrence. None of
the proposed solutions have yet been implemented. These include:

Ben Bernanke: Establish resolution procedures for closing troubled financial institutions
in the shadow banking system, such as investment banks and hedge funds.[190]
Nassim Nicholas Taleb: "Black Swan Robustness" i.e. Robustness against High Impact
Rare Events("Fat Tails").
Joseph Stiglitz: Restrict the leverage that financial institutions can assume. Require
executive compensation to be more related to long-term performance. Re-instate the
separation of commercial (depository) and investment banking established by the Glass
Steagall Act in 1933 and repealed in 1999 by the Gramm-Leach-Bliley Act.
Simon Johnson: Break-up institutions that are "too big to fail" to limit systemic risk.
Paul Krugman: Regulate institutions that "act like banks" similarly to banks.
Alan Greenspan: Banks should have a stronger capital cushion, with graduated regulatory
capital requirements (i.e., capital ratios that increase with bank size), to "discourage them
from becoming too big and to offset their competitive advantage."
Warren Buffett: Require minimum down payments for home mortgages of at least 10%
and income verification.
Eric Dinallo: Ensure any financial institution has the necessary capital to support its
financial commitments. Regulate credit derivatives and ensure they are traded on wellcapitalized exchanges to limit counterparty risk.
Raghuram Rajan: Require financial institutions to maintain sufficient "contingent capital"
(i.e., pay insurance premiums to the government during boom periods, in exchange for
payments during a downturn.).
HM Treasury: Contingent capital or capital insurance held by the private sector could
supplement common equity in times of crisis. There are a variety of proposals (e.g. Raviv
2004, Flannery 2009) under which banks would issue fixed income debt that would
convert into capital according to a predetermined mechanism, either bank-specific
(related to levels of regulatory capital) or a more general measure of crisis. Alternatively,
under capital insurance, an insurer would receive a premium for agreeing to provide an
amount of capital to the bank in case of systemic crisis. Following Raviv (2004)
proposal, on November 3 Lloyds Banking Group (LBG), Britains biggest retail bank,
said it would convert existing debt into about 7.5 billion ($12.3 billion) of contingent
core Tier-1 capital (dubbed CoCos). This is a kind of debt that will automatically
convert into shares if the banks cushion of equity capital falls below 5%.
A. Michael Spence and Gordon Brown: Establish an early-warning system to help detect
systemic risk.
Niall Ferguson and Jeffrey Sachs: Impose haircuts on bondholders and counterparties
prior to using taxpayer money in bailouts. In other words, bondholders with a claim of
$100 would have their claim reduced to $80, creating $20 in equity. This is also called a
debt for equity swap. This is frequently done in bankruptcies, where the current

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shareholders are wiped out and the bondholders become the new stockholders, agreeing
to reduce the company's debt burden in the process. This is being done with General
Motors, for example.
Nouriel Roubini: Nationalize insolvent banks. Reduce mortgage balances to assist
homeowners, giving the lender a share in any future home appreciation.
Adair Turner: In August 2009 in a roundtable interview in Prospect Adair Turner
supported the idea of new global taxes on financial transactions, warning that a swollen
financial sector paying excessive salaries has grown too big for society. Lord Turners
suggestion that a Tobin tax named after the economist James Tobin should be
considered for financial transactions reverberated around the world.
Let Wall Street Pay for the Restoration of Main Street Bill - in the US only (not
international) - Proposed legislation introduced December 3, 2009 - Contained in the US
House of Representatives bill entitled "H.R. 4191: Let Wall Street Pay for the Restoration
of Main Street Act of 2009" It is a proposed piece of legislation that was introduced into
the United States House of Representatives to assess a minuscule tax on US Financial
market ("Wall Street") securities transactions. If passed, the money it generates will be
used to rebuild "Main Street." On the day it was introduced, it had the support of 22
representatives.
Volcker Rule - (in US) - Endorsed by President Barack Obama on January 21, 2010. At
its heart, it is a proposal by US economist Paul Volcker to restrict banks from making
speculative investments that do not benefit their customers. Volcker has argued that such
speculative activity played a key role in the financial crisis of 20072010.
The Financial Crisis Responsibility Fee is a proposed tax by U.S. President Barack
Obama on certain financial firms that would be imposed until the financial firm had paid
off all money provided to it under the Troubled Assets Relief Program. It was proposed in
January 2010.
On April 16, 2010, the IMF proposed two types of global taxes on banks: The "Financial
Activities Tax" comes in two varieties. The simple version is a straight tax on a bank's
gross profitsbefore deducting compensation. A "financial stability contribution", would
initially be at a flat rate, this would eventually be refined so that riskier businesses paid
more. The second, more complex tax aims directly at excess bank profit and pay. (See
also Bank tax)
Maximum wage is an idea which has been enacted in early 2009 in the United States,
where they capped executive pay at $500,000 per year for companies receiving
extraordinary financial assistance from the US Taxpayers.
Don Tapscott writes about the need for transparency in the banking industry using a
different kind of financial innovation in his book Macrowikinomics, drawing on the
power of the crowd to value financial securities.

United States Congress response

On December 11, 2009 - House cleared bill H.R.4173 - Wall Street Reform and
Consumer Protection Act of 2009
On April 15, 2010 - Senate introduced bill S.3217 - Restoring American Financial
Stability Act of 2010
On July 21, 2010. - the Dodd-Frank Wall Street Reform and Consumer Protection Act
was enacted.

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