PROJECT REPORT

ON

FINANCIAL CRISIS IN U.S.

SUBMITTED BY
ARUN PUNDIR
YAMINI BHUSHAN PANDEY
(FINANCIAL SERVICES)

SUBMITTED TO
PROF. MAHIMA SHARMA
JAIPURIA INSTITUTTE OF MANAGEMENT
LUCKNOW (U.P.)
 Financial Crisis

The term financial crisis is applied broadly to a variety of situations in

which some financial institutions or assets suddenly lose a large part
of their value. In the 19th and early 20th with banking panics, and
many recessions coincided with these panics. Other situations that are
often called financial crises include stock market crashes and the
bursting of other financial bubbles, currency crises, and sovereign
defaults centuries, many financial crises were associated
Many economists have offered theories about how financial crises
develop and how they could be prevented. There is little consensus,
however, and financial crises are still a regular occurrence around the
world.

Causes Of Financial Crisis

Strategic complementarities in financial markets

It is often observed that successful investment requires each investor
in a financial market to guess what other investors will do. George
Soros has called this need to guess the intentions of others
'reflexivity'. Similarly, John Maynard Keynes compared financial
markets to a beauty contest game in which each participant tries to
predict which model other participants will consider most beautiful.
Furthermore, in many cases investors have incentives
to coordinate their choices. For example, someone who thinks other
investors want to buy lots of Japanese yen may expect the yen to rise
in value, and therefore has an incentive to buy yen too. Likewise, a
depositor in IndyMac Bank who expects other depositors to withdraw
their funds may expect the bank to fail, and therefore has an incentive
to withdraw too. Economists call an incentive to mimic the strategies
of others strategic complementarity.
It has been argued that if people or firms have a sufficiently strong
incentive to do the same thing they expect others to do, then self-
fulfilling prophecies may occur. For example, if investors expect the
value of the yen to rise, this may cause its value to rise; if depositors
expect a bank to fail this may cause it to fail.Therefore, financial
crises are sometimes viewed as a vicious circle in which investors
shun some institution or asset because they expect others to do so.

Leverage
Leverage, which means borrowing to finance investments, is
frequently cited as a contributor to financial crises. When a financial
institution (or an individual) invests its own money, it can, in the very
worst case, lose its own money. But when it borrows in order to invest
more, it can potentially earn more from its investment, but it can also
lose more than all it has. Therefore leverage magnifies the potential
returns from investment, but also creates a risk of bankruptcy. Since
bankruptcy means that a firm fails to honor all its promised payments
to other firms, it may spread financial troubles from one firm to
another .
The average degree of leverage in the economy often rises prior to a
financial crisis. For example, borrowing to finance investment in
the stock market ("margin buying") became increasingly common
prior to the Wall Street Crash of 1929.

Asset-liability mismatch
Another factor believed to contribute to financial crises is asset-
liability mismatch, a situation in which the risks associated with an
institution's debts and assets are not appropriately aligned. For
example, commercial banks offer deposit accounts which can be
withdrawn at any time and they use the proceeds to make long-term
loans to businesses and homeowners. The mismatch between the
banks' short-term liabilities (its deposits) and its long-term assets (its
loans) is seen as one of the reason bank runs occur (when depositors
panic and decide to withdraw their funds more quickly than the bank
can get back the proceeds of its loans). Likewise, Bear Stearns failed
in 2007-08 because it was unable to renew the short-term debt it used
to finance long-term investments in mortgage securities.
In an international context, many emerging market governments are
unable to sell bonds denominated in their own currencies, and
therefore sell bonds denominated in US dollars instead. This
generates a mismatch between the currency denomination of their
liabilities (their bonds) and their assets (their local tax revenues), so
that they run a risk of sovereign default due to fluctuations in
exchange rates.

Regulatory failures
Governments have attempted to eliminate or mitigate financial crises
by regulating the financial sector. One major goal of regulation
is transparency: making institutions' financial situation publicly
known by requiring regular reporting under standardized accounting
procedures. Another goal of regulation is making sure institutions
have sufficient assets to meet their contractual obligations,
through reserve requirements, capital requirements, and other limits
on leverage.
Some financial crises have been blamed on insufficient regulation,
and have led to changes in regulation in order to avoid a repeat. For
example, the Managing Director of the IMF,Dominique Strauss-
Kahn, has blamed the financial crisis of 2008 on 'regulatory failure to
guard against excessive risk-taking in the financial system, especially
in the US'.[17] Likewise, the New York Times singled out the
deregulation of credit default swaps as a cause of the crisis.
However, excessive regulation has also been cited as a possible cause
of financial crises. In particular, the Basel II Accord has been
criticized for requiring banks to increase their capital when risks rise,
which might cause them to decrease lending precisely when capital is
scarce, potentially aggravating a financial crisis.

Fraud
Fraud has played a role in the collapse of some financial institutions,
when companies have attracted depositors with misleading claims
about their investment strategies, or have embezzled the resulting
income. Examples include Charles Ponzi's scam in early 20th century
Boston, the collapse of the MMM investment fund in Russia in 1994,
and the scams that led to the Albanian Lottery Uprising of 1997.
Many rogue traders that have caused large losses at financial
institutions have been accused of acting fraudulently in order to hide
their trades. Fraud in mortgage financing has also been cited as one
possible cause of the 2008 subprime mortgage crisis; government
officials stated on Sept. 23, 2008 that the FBI was looking into
possible fraud by mortgage financing companies Fannie
Mae and Freddie Mac, Lehman Brothers, and insurer American
International Group.

Contagion
Contagion refers to the idea that financial crises may spread from one
institution to another, as when a bank run spreads from a few banks to
many others, or from one country to another, as when currency crises,
sovereign defaults, or stock market crashes spread across countries.
When the failure of one particular financial institution threatens the
stability of many other institutions, this is called systemic risk.
One widely-cited example of contagion was the spread of the Thai
crisis in 1997 to other countries like South Korea. However,
economists often debate whether observing crises in many countries
around the same time is truly caused by contagion from one market to
another, or whether it is instead caused by similar underlying
problems that would have affected each country individually even in
the absence of international linkages.

Recessionary effects
Some financial crises have little effect outside of the financial sector,
like the Wall Street crash of 1987, but other crises are believed to
have played a role in decreasing growth in the rest of the economy.
There are many theories why a financial crisis could have a
recessionary effect on the rest of the economy. These theoretical ideas
include the 'financial accelerator', 'flight to quality' and 'flight to
liquidity', and the Kiyotaki-Moore model. Some 'third generation'
models of currency crises explore how currency crises and banking
crises together can cause recessions.

Origin Of U.S.Crisis

Week of September 7, 2008

The United States director of the Federal Housing Finance
Agency (FHFA), James B. Lockhart III, on September 7, 2008
announced his decision to place two United States Government
sponsored enterprises (GSEs), Fannie Mae (Federal National
Mortgage Association) and Freddie Mac (Federal Home Loan
Mortgage Corporation), into conservatorship run by FHFA.
United States Treasury Secretary Henry Paulson, at the same press
conference stated that placing the two GSEs into conservatorship
was a decision he fully supported, and said that he advised "that
conservatorship was the only form in which I would commit
taxpayer money to the GSEs." He further said that "I attribute the
need for today's action primarily to the inherent conflict and
flawed business model embedded in the GSE structure, and to the
ongoing housing correction." The same day, Federal Reserve
Bank Chairman Ben Bernanke stated in support: "I strongly
endorse both the decision by FHFA Director Lockhart to place
Fannie Mae and Freddie Mac into conservatorship and the actions
taken by Treasury Secretary Paulson to ensure the financial
soundness of those two companies."
Week of September 14, 2008
Major financial firm crisis
On Sunday, September 14, it was announced that Lehman
Brothers would file for bankruptcy after the Federal Reserve Bank
declined to participate in creating a financial support facility for
Lehman Brothers. The same day, the sale of Merrill
Lynch to Bank of America was announced. The beginning of the
week was marked by extreme instability in global stock markets,
with dramatic drops in market values on Monday, September 15,
and Wednesday, September 17. On September 16, the large
insurer American International Group (AIG), a significant
participant in the credit default swaps markets suffered a liquidity
crisis following the downgrade of its credit rating. The Federal
Reserve, at AIG's request, and after AIG has shown that it could
not find lenders willing to save it from insolvency, created a credit
facility for up to US$85 billion in exchange for an 79.9% equity
interest, and the right to suspend dividends to previously issued
common and preferred stock.
Money market funds insurance and short sales prohibitions
On September 16, the Reserve Primary Fund, a large money
market mutual fund, lowered its share price below $1 because of
exposure to Lehman debt securities. This resulted in demands
from investors to return their funds as the financial crisis
mounted. By the morning of September 18, money market sell
orders from institutional investors totalled $0.5 trillion, out of a
total market capitalization of $4 trillion, but a $105 billion
liquidity injection from the Federal Reserve averted an immediate
collapse. On September 19 the U.S. Treasury offered temporary
insurance (akin to FDIC insurance of bank accounts) to money
market funds. Toward the end of the week, short selling of
financial stocks was suspended by the Financial Services
Authority in the United Kingdom and by the Securities and
Exchange Commission in the United States. Similar measures
were taken by authorities in other countries. Some restoration of
market confidence occurred with the publicity surrounding efforts
of the Treasury and the Securities Exchange Commission
Troubled Asset Relief Program
On September 19, 2008, a plan intended to ameliorate the
difficulties caused by the subprime mortgage crisis was
proposed by the Secretary of the Treasury, Henry Paulson. He
proposed a Troubled Asset Relief Program, later incorporated
into the Emergency Economic Stabilization Act of 2008,
which would permit for the United States government to
purchase illiquid assets, also termed toxic assets, from
financial institutions. The value of the securities is extremely
difficult to determine.
Consultations between the Secretary of the Treasury,
the Chairman of the Federal Reserve, and the Chairman of
the U.S. Securities and Exchange Commission, Congressional
leaders and the President of the United States moved forward
plans to advance a comprehensive solution to the problems
created by illiquid mortgage-backed securities. At the close of
the week the Secretary of the Treasury and President Bush
announced a proposal for the federal government to buy up to
US$700 billion of illiquid mortgage backed securities with the
intent to increase the liquidity of the secondary mortgage
markets and reduce potential losses encountered by financial
institutions owning the securities. The draft proposal of the
plan was received favorably by investors in the stock market.
Details of the bailout remained to be acted upon by Congress.
Week of September 21, 2008
On Sunday, September 21, the two remaining investment
banks, Goldman Sachs and Morgan Stanley, with the approval
of the Federal Reserve, converted to bank holding companies,
a status subject to more regulation, but with readier access to
capital. On September 21, Treasury Secretary Henry
Paulson announced that the original proposal, which would
have excluded foreign banks, had been widened to include
foreign financial institutions with a presence in the US. The
US administration was pressuring other countries to set up
similar bailout plans.
On Monday and Tuesday during the week of September 22,
appearances were made by the Secretary of the Treasury and
the Chairman of the Board of Governors of the Federal
Reserve before Congressional committees and on Wednesday
a prime time presidential address was delivered by the
President of the United States on television. Behind the
scenes, negotiations were held refining the proposal which had
grown to 42 pages from its original 3 and was reported to
include both an oversight structure and limitations on
executive salaries, with other provisions under consideration.
On September 25, agreement was reported by congressional
leaders on the basics of the package; however, general and
vocal opposition to the proposal was voiced by the public. On
Thursday afternoon at a White House meeting attended by
congressional leaders and the presidential candidates, John
McCain and Barack Obama, it became clear that there was no
congressional consensus, with Republican representatives and
the ranking member of the Senate Banking
Committee, Richard C. Shelby, strongly opposing the
proposal. The alternative advanced by conservative House
Republicans was to create a system of mortgage insurance
funded by fees on those holding mortgages; as the working
week ended, negotiations continued on the plan, which had
grown to 102 pages and included mortgage insurance as an
option. On Thursday evening Washington Mutual, the nation's
largest savings and loan, was seized by the Federal Deposit
Insurance Corporation and most of its assets transferred
to JPMorgan Chase. Wachovia, one of the largest US banks,
was reported to be in negotiations with Citigroup and other
financial institutions.
Week of September 28, 2008
Early into Sunday morning an announcement was made by the
United States Secretary of the Treasury and congressional
leaders that agreement had been reached on all major issues:
the total amount of $700 billion remained with provision for
the option of creating a scheme of mortgage insurance.
It was reported on Sunday, September 28, that a rescue plan
had been crafted for the British mortgage lender Bradford &
Bingley. Grupo Santander, the largest bank in Spain, was
slated to take over the offices and savings accounts while the
mortgage and loans business would be nationalized.
Fortis, a huge Benelux banking and finance company was
partially nationalized on September 28, 2008, with Belgium,
the Netherlands and Luxembourg investing a total of 11.2
billion euros (16.3 billion U.S. dollars) in the bank. Belgium
will purchase 49% of Fortis's Belgian division, with the
Netherlands doing the same for the Dutch division.
Luxembourg has agreed to a loan convertible into a 49% share
of Fortis's Luxembourg division.
It was reported on Monday morning, September 29,
that Wachovia, the 4th largest bank in the United States,
would be acquired by Citigroup.
On Monday the German finance minister announced a rescue
of Hypo Real Estate, a Munich-based holding company
comprised of a number of real estate financing banks, but the
deal collapsed on Saturday, 4 October.
The same day the government of Iceland
nationalized Glitnir, Iceland’s third largest lender.
Stocks fell dramatically Monday in Europe and the US despite
infusion of funds into the market for short term credit. In the
US the Dow dropped 777 points (6.98%), the largest one-day
point-drop in history (but only the 17th largest percentage
drop).
The U.S. bailout plan, now named the Emergency Economic
Stabilization Act of 2008 and expanded to 110 pages was
slated for consideration in the House of Representatives on
Monday, September 29 as HR 3997 and in the Senate later in
the week. The plan failed after the vote being held open for 40
minutes in the House of Representatives, 205 for the plan, 228
against. Meanwhile US stock markets suffered steep declines,
the Dow losing 300 points in a matter of minutes, ending
down 777.68, the Nasdaq losing 199.61, falling below the
2000 point mark, and the S.&P. 500 off 8.77% for the day. By
the end of the day, the Dow suffered the largest drop in the
history of the index. The S&P 500 Banking Index fell 14% on
September 29 with drops in the stock value of a number of US
banks generally considered sound, including Bank of New
York Mellon, State Street and Northern Trust; three Ohio
banks, National City, Fifth Third, and KeyBank were down
dramatically.
On Tuesday, September 30, stocks rebounded but credit
markets remained tight with the London Interbank Offered
Rate (overnight dollar Libor) rising 4.7% to 6.88%.
On Tuesday, September 30, 9 billion was made available by
the French, Belgian and Luxembourg governments to the
French-Belgian bank Dexia.
After Irish banks came under pressure on Monday, September
29, the Irish government undertook a two year "guarantee
arrangement to safeguard all deposits (retail, commercial,
institutional and inter-bank), covered bonds, senior debt and
dated subordinated debt (lower tier II)" of 6 Irish banks: Allied
Irish Banks, Bank of Ireland, Anglo Irish Bank, Irish Life and
Permanent, Irish Nationwide and the EBS Building Society;
the potential liability involved is about 400 billion dollars.
The United States Senate's version of the $700 billion bailout
plan, HR1424, modified to expand bank deposit guarantees to
$250,000 and to include $100 billion in tax breaks for
businesses and alternative energy, passed with bi-partisan
support 74-25 on October 1st. Reaction in the House was
mixed, but in a vote on Friday the House of Representatives
passed the Emergency Economic Stabilization Act of 2008, as
refashioned by the Senate, 263-171 in a bipartisan vote.
Discussions were ongoing in Europe regarding possible
remedies for financial instability in Europe leading up to a
conference Saturday afternoon in Paris hosted by Nicolas
Sarkozy, president of France. UniCredit of Italy was reported
to be the latest bank to come under pressure. During the night
of October 2 Greece followed Ireland's lead and guaranteed all
bank deposits.
On October 3 it was reported that Wachovia had rejected the
previous offer from Citigroup in favor of acquisition by Wells
Fargo,[64] resulting in a legal dispute with Citigroup.
In Britain, the Financial Services Authority announced on
October 3 that effective Tuesday, October 7, the amount of the
guarantee of bank deposits would be raised to £50,000 from
£35,000. On Friday, October 3, the government of the
Netherlands took over the Dutch operations of Fortis,
replacing the bailout plan of September 28.
Week of October 5
Over the weekend and on Monday a major banking and
financial crisis emerged in Iceland with its currency the krona,
dropping 30% against the euro. At a meeting on Monday night
emergency legislation was passed granting broad powers to
the government to seize and regulate banks.
The Landsbanki and Glitnir were seized, while Kaupthing was
subjected to a rescue plan.
On October 6, the Icelandic Financial Supervisory
Authority decided temporarily to suspend from trading on
regulated markets all financial instruments issued by Glitnir
banki hf., Kaupþing banki hf., Landsbanki Íslands
hf., Straumur-Burðarás fjárfestingarbanki hf., Spron hf.,
and Exista hf.[70]
Before the opening of the business day, October 6. BNP
Paribas, the French bank, assumed control of the remaining
assets of Fortis following Dutch nationalization of the
operations of the bank in The Netherlands. Denmark, Austria,
and possibly Germany, joined Ireland and Greece in
guaranteeing bank deposits on Monday, October 6. Following
this, the FTSE100 index of leading British shares took its
worst one-day hit in history. A banking Bill easing rescues is
slated for introduction in the British Parliament on Tuesday,
October 7. On 6 October German chancellor Angela
Merkel pledged that the government would guarantee all
German private bank savings. The government also
announced a revised bailout plan for German mortgage
lender Hypo Real Estate (HRE). On Monday, October 6, the
Dow Jones Industrial Average closed below 10,000, a drop of
30% from its high above 14,000 a year earlier on October 9,
2007. In Brazil and Russia trading was suspended on Monday
following dramatic drops in their markets.
On October 7, the Icelandic Financial Supervisory
Authority took control of Landsbanki. On the same day,
the Central Bank of Iceland announced that Russia had agreed
to provide a four-billion-euro loan, however this was soon
denied by Russian authorities, and the Icelandic Finance
Minister had to correct the earlier announcement and now
stated that discussions had been initiated with Russia on
providing a loan to Iceland. This was also denied by Russian
Deputy Finance Minister Dmitry Pankin. Late in the evening,
however, Russia's Finance Minister Alexei Kudrin did
concede that a request had been received, to which Russia was
positive, and that discussions on financial matters would be
conducted later in the week when an Icelandic delegation was
expected to arrive in Moscow. Standard & Poor's also cut
Iceland's foreign-currency sovereign credit rating from A-/A-2
to BBB/A-3 and local-currency sovereign credit rating from
A+/A-1 to BBB+/A-2. S&P also lowered Iceland's banking
industry country risk assessment from group 5 to group 8,
worrying that "In a severe recession scenario, the cumulative
amount of nonperforming and restructured loans could reach
35% to 50% of total outstanding loans in Iceland.
On October 7 the Federal reserve announced formation of a
Commercial Paper Funding Facilty (CPFF) which will serve
as a funding backstop to facilitate the issuance of term
commercial paper by eligible issuers. Several countries
announced new or increased deposit guarantees: Taiwan
outlined plans to double the guarantee to NT$3 million
($92,000) and the European Union agreed to increase
guarantees across the EU to at least €50,000 per saver. Several
EU states then announced increases on top of this
minimum: Netherlands, Spain,Belgium, and Greece each
announced they would guarantee up to €100,000.
The government of Britain announced on the morning of
Wednesday, October 8 that it would make £25 billion
available as "Tier 1 capital" (preference share capital or
"PIBS" [Permanent Interest-Bearing Securities]) to the
following financial
institutions: Abbey, Barclays, HBOS, HSBC Bank plc, Lloyds
TSB, Nationwide Building Society, Royal Bank of Scotland,
andStandard Chartered as part of a bank rescue package. An
additional £25 billion was scheduled to be made available to
other financial institutions, including British subsidiaries of
foreign banks. "In reviewing these applications the
Government will give due regard to an institution's role in the
UK banking system and the overall economy". The plan
included increased ability to borrow from the government,
offered assistance in raising equity, and a statement of support
for international efforts. The plan has been characterized as
partial nationalization.
On Wednesday, October 8, the European Central Bank, Bank
of England, Federal Reserve, Bank of Canada, Swedish
Riksbank and Swiss National Bank all announced
simultaneous cuts of 0.5% to their base rates at 11:00
UTC. Shortly afterwards, the Central Bank of the People's
Republic of China also cut interest rates. On October 8 there
were sharp losses on stock markets worldwide with a loss of
over 9% in Japan. Trading was suspended in Russia and
Indonesia after steep morning losses. In the United States,
following the funds cut by the Federal Reserve, stocks were
volatile, finishing down. On October 8 the Federal Reserve
loaned AIG $37.8 billion, in addition to the previous loan of
$85 billion.
On Wednesday night, October 8, the Central Bank of
Iceland abandoned its attempt to peg the Icelandic króna at
131 króna to the euro after trying to set this peg on Monday,
October 6. By Thursday October 9, the Icelandic króna was
trading at 340 to the euro when the government suspended all
trade in the currency.
On Thursday, October 9, the Icelandic Financial Supervisory
Authority took control of the country's biggest bank Kaupþing
banki hf. This occurred when the Kaupthing Board resigned
and asked the national authorities to take control. This came
about when "Britain transferred control of the business
of Kaupthing Edge, its Internet bank, to ING Direct and put
Kaupthing's UK operations into administration"
placing Kaupthing in technical default according to loan
agreements. This marked an escalating row
between Iceland and the United Kingdom over the growing
crisis. All trade was also suspended on the Iceland Stock
Exchange until Monday October 13.
On Thursday, October 9, the one-year anniversary of
the Dow's peak, the cost of short term credit rose while there
were heavy losses in the United States stock market;
the Dow dropped below 8600, reaching a five year low. It was
the first time since August 2003 that the Dow closed below
9000; losses were moderate in Europe. The following day,
Friday, October 10, there were large losses in Asian and
European markets  Yamato Life filed for bankruptcy. Beset by
falling commodities prices, Russia's stock markets remained
closed on October 10. The Russian Parliament passed a plan
authorizing lending of $36 billion gained from global oil sales
to banks which met creditworthiness requirements. Special
attention is being paid to shoring up Rosselkhozbank, the bank
which provides credit to the reviving agricultural sector. The
amount of funds available is limited due to falling oil
prices. The government of the United States, as authorized
by the Emergency Economic Stabilization Act, announced
plans to infuse funds into banks by purchasing equity interests
in them, in effect, partial nationalization, as done in Britain.
The Treasury secretary Henry M. Paulson Jr. met Friday in
Washington with world financial leaders. A meeting of
international financial leaders hosted by President Bush at the
White House in Washington is planned on Saturday to attempt
to coordinate global response to the financial crisis. The
annual meetings of both the International Monetary Fund and
World Bank was scheduled to be held in Washington over that
weekend.
On Friday, October 10th, stock markets crashed across Europe
and Asia. London, Paris and Frankfurt dropped 10% within an
hour of trading and again when Wall Street opened for trading.
Global markets have experienced their worst weeks since
1987 and some indexes, S&P 500, since the Wall Street Crash
of 1929.
On October 10th, within the first five minutes of the trading
session on Wall Street, the Dow Jones Industrial
Average plunged 697 points, falling below 7900 to its lowest
level since March 17, 2003. Later in the afternoon, the Dow
made violent swings back and forth across the breakeven line,
toppling as much as 600 points and rising 322 points. The
Dow ended the day losing only 128 points, or 1.49%. Trading
on New York Stock Exchange closed for the week with the
Dow at 8,451, down 1,874 points, or 18% for the week, and
after 8 days of losses, 40% down from its record high October
9, 2007. Trading on Friday was marked by extreme volatility
with a steep loss in the first few minutes followed by a rise
into positive territory, closing down at the end of the day. In
S&P100 some financial corporate showing signals upwards
also. President George W. Bush reassured investors that the
government will solve the financial crisis gripping world
economies.
The bonds of the bankrupt Lehman Brothers were auctioned
on Friday, October 10. They sold for a little over 8 cents on
the dollar. Many of the bonds of Lehman Brothers were
insured withcredit default swaps. There is apprehension that
payments to the holders of Lehman bonds may severely
damage the firms or hedge funds which issued the swaps.
Anticipated claims are estimated to be several hundred billion
dollars.
As meetings proceeded with global financial leaders in
Washington on Saturday, October 11, the United States
government announced a change in emphasis in its rescue
efforts from buying illiquid assets to recapitalizing banks,
including strong banks, in exchange for preferred equity; and
purchase of mortgages by Fannie Mae and Freddie Mac.
These remedies can be put into effect quicker than the prior
plan which was estimated to take a month to set into
operation.
Week of October 12
On Sunday the British government was in negotiations with
Royal Bank of Scotland, HBOS, Lloyds TSB and Barclays,
major British banks, regarding recapitalization which would
give the British government a substantial equity interest. An
investment of more than 37 billion pounds is contemplated.
Some purchases would be common stock with existing
shareholders given a right of first refusal (the government
would only purchase the shares if existing shareholders did
not). Previously announced recapitalization plans
contemplated only purchases of preferred equity without
government participation in governance of the banks,
however, as the financial emergency has rapidly developed,
more aggressive measures are being advanced. On Sunday,
October 12, European leaders, meeting in Paris, led by France
and Germany, announced recapitalization plans for Europe's
banks. Plans were announced to guarantee bank deposits for
five years. European countries would finance their own rescue
plans and tailor them to local conditions. Mechanisms are also
planned to increase the availability of short term credit. The
total rescue plan totaled 1 trillion euros. Australia and New
Zealand also announced bank guarantee plans. On Monday,
October 13, the markets were closed in Japan and the bond
market was closed in the United States.
On Sunday, in Norway, which is not in the euro zone,
the Norwegian cabinet in a hastily called press conference
announced a US$57.4 billion (350 billion Norwegian kroner)
plan of offering Norwegian banks new government bonds.
This came three days ahead of Wednesday's hastened interest
rate meeting at Norges Bank to decide whether or not to
announce rate cuts similar to the coordinated cuts of October
8. Central bank Governor Svein Gjedrem also made critical
comments about some of the measures that had been
implemented already by other countries, among them the
concerted rate cuts which he said "was a strong card, which
had a two-hour impact". He further commented that "It's
important to be careful with measures  – so that one addresses
the problems one really faces," and he also emphasized that
acting at the right time was important saying "there are
unusually many examples that show one can do too much too
early." He cited the Icelandic government's takeover of banks
as an example of quick action with no guarantee that the
problems would be solved.
The G7 nations, at their meeting in Washington over the
weekend pledged to "support systemically important financial
institutions and prevent their failure". This decision is based
on analysis of the consequences of the bankruptcy of Lehman
Brothers which resulted in the loss of funds by other financial
institutions. It is thought that those losses may have triggered a
tightening of the credit crunch as banks ceased to lend to one
another. No enforceable mechanism was created to support the
pledge, but it is believed to extend to major firms such as
Morgan Stanley and Goldman Sachs.
On October 13 stock markets worldwide rose with the Dow
Jones industrial average showing a 400 point leap at the start
of trading. At the close of trading the average was up 936
points, a record climb, up 11%, closing above 9,000 at
9,387. After announcement in France of a 320 billion euro
rescue and guarantee plan, French CAC40 rose by 11.18%
within the day. Germany announced a 400 billion euro plan.
On Monday the International Monetary Fund offered possible
technical and financial aid to Hungary which has suffered
during the crisis due to the flight of investors to euro, Swiss
franc, and dollar denominated investments. As in the rest of
the world, on Monday stock prices rose on the Hungarian
exchange and pressure on the national currency,
the forint eased. The forint has dropped 30% against the dollar
since July. The prime minister of Spain, Jose Luis Rodriguez
Zapatero, announced that Spain would provide up to €100
billion of guarantees for new debt issued by commercial banks
in 2008. This plan followed a meeting at the eurozone summit
over the weekend to try to develop a coordinated effort to
combat the credit crisis. The UK government started the
nationalization process by injecting £37 billion in the nation’s
three largest banks. The UK government would end up
owning a majority share in the Royal Bank of Scotland (RBS)
and over a 40% share in Lloyds and HBOS. In return for the
bailout, the banks agreed to cancel dividend payments until
the loans are repaid, have board members appointed by the
Treasury, and limit executive pay. The European Central Bank
attempted to revive credit market by weekly injections of
unlimited euro funds at an interest rate of 3.75%. The ECB
president, Jean-Claude Trichet, was also contemplating
relaxing the collateral standards to make the funds more
accessible to banks. Following its European partners, Italy
pledged to intervene as necessary to prevent any bank failures
in its country. Finance minister, Giulio Tremonti, said Italy
would guarantee new bank bonds of up to 5 years until the end
of 2009 and the Bank of Italy would provide €40 billion in
treasury bills to banks to refinance inferior assets that can not
be currently used as collateral. In coordination with other
eurozone countries, the Dutch government announced that it
would guarantee interbank lending up to €200 billion. This
followed the set up of a €20 billion Dutch fund to help
recapitalize banks and insurers.
On Tuesday the United States announced a plan to take an
equity interest of $250 billion in US banks with 25 billion
going to each of the four largest banks. The 9 largest banks in
the US: Goldman Sachs, Morgan Stanley, J.P. Morgan, Bank
of America, Merrill Lynch, Citigroup, Wells Fargo, Bank of
New York Mellon and State Street were called in to a meeting
on Monday morning and pressured to sign; all eventually
agreed. The plan will be open to any bank for 30 days. The
equity interests purchased by the government are preferred
shares that pay 5% but rise to 9% after 5 years; it is expected
that the companies will repurchase this interest when they can
raise private capital to do so. The plan also includes an option
allowing the government to purchase common stock according
to a formula which could return substantial profit to the
taxpayers should the stock price of the companies
substantially appreciate. The total liability assumed is $2.25
trillion including a $1.5 trillion guarantee of new senior debt
issued by banks and a $500 billion guarantee of deposits in
noninterest-bearing accounts (business accounts used to pay
current obligations such as payroll). The theory is that with
additional capitalization and the guarantees, banks will be
willing to resume a normal lending pattern with each other and
borrowers.
Also on that day, United Arab Emirates’ (UAE) ministry of
finance added a $19 billion liquidity injection to domestic
banks bringing the total dollars injected to $32.7 billion. The
UAE central bank offered 13.6 billion in liquidity to help
domestic banks in September. To protect local deposits, the
UAE government guaranteed all deposits and interbank
lending. Japan announced a plan that will help steady the
Japanese market and avoid the worse of the credit crisis.
Among the measures included are lifting restrictions on
companies buying back their shares, strengthening disclosure
on short selling, and the temporary suspension of the sale of
government-owned stocks. The Australian government
unveiled a $10.4 billion stimulus package. The Economic
Security Strategy is designed to help pensioners, low and
middle income families, and first time home buyers withstand
the credit crisis and global economic slowdown. This followed
the Australian government announcing that it would guarantee
all bank deposits for three years, guarantee all term
wholesaling funding by Australian banks in international
markets and double its planned purchase of residential
mortgage backed securities. The Icelandic stock exchange
began trading again after a three day shutdown. The opening
did not include Iceland’s three largest banks which were
nationalized last week.
On Wednesday, October 15, the London stock exchange FTSE
100 fell substantially, surrendering over 314 points to slip
down 7.16 percent. The losses precipitated more losses in the
U.S., as the Dow Jones Industrial Average suffered its largest
drop in terms of percentage since 1987, falling over 733
points. The NASDAQ plunged almost eight and a half percent,
and theStandard & Poor collapsed down over nine percent.
On October 16, a rescue plan was announced for the Swiss
banks UBS and Credit Suisse. Recapitalization involved Swiss
government funds, private investors, and the sovereign wealth
fund of Qatar. A Swiss agency was set up to purchase and
workout toxic funds. UBS had suffered substantial
withdrawals by domestic Swiss depositors but still reported
profits; Credit Suisse has reported losses. Most large banks in
the United States continued to report large losses.
Week of October 19
On Sunday, October 19 the government of the Netherlands
bailed out ING, the Dutch bank, with a €10 billion capital
rescue plan. On Monday the government of Belgium rescued
the insurance company Ethias with a €1.5 billion capital
injection. In Germany BayernLB has decided to apply for
funds from the German €500 billion rescue program. Sweden
announced formation of a 1.5 trillion kronor fund to support
inter-bank lending and a 15 billion kronor capital injection
plan. Swedish banks were reported to be increasingly affected
by the financial crisis. An IMF rescue plan for Iceland was
reported to be near finalization while Ukraine was reported to
be in discussions with the IMF. Iceland was reported to have
also received assistance from Denmark and Norway while
Britain has offered a loan to support compensation of British
depositors in failed Icelandic bank Landsbanki. On Monday
France announced a €10.5 billion rescue plan for six of its
largest banks, including Crédit Agricole, BNP and Société
Générale.
 IMPACT ON U.S.
In the early months of 2008, many observers believed that a
U.S. recession had begun. As a direct result of the collapse of Bear
Stearns, Global Insight increased the probability of a worse-than-
expected recession to 40% (from 25% before the collapse). In
addition, financial market turbulence signaled that the crisis will not
be mild and brief.
Alan Greenspan, ex-Chairman of the Federal Reserve, stated in March
2008 that the 2008 financial crisis in the United States is likely to be
judged as the harshest since the end of World War II. A chief
economist at Standard & Poor's, said in March 2008 he has a worst-
case-scenario in which the country could endure a double-dip
recession in which the economy would briefly recover in the summer
2008. Under this scenario, the economy's total output, as measured by
the gross domestic product, would drop by 2.2 percentage points,
making it the third worst recession in the post World War II period.
The former head of the National Bureau of Economic Research said
in March 2008 he believed the country was then in a recession, and it
could be a severe one. A number of private economists generally
predicted a mild recession ending in the summer of 2008 when
the economic stimulus checks going to 130 million households started
being spent. A chief economist at Moody's predicted in March 2008
that policymakers would act in a concerted and aggressive way to
stabilize the financial markets, and that then the economy would
suffer but not enter a prolonged and severe recession. It takes many
months before the National Bureau of Economic Research-committee,
the unofficial arbiter of when recessions begin and end, makes its own
ruling.
According to numbers published by Bureau of Economic Analysis in
May 2008, the GDP growth of the previous two quarters was positive.
As one common definition of a recession is negative economic
growth for at least two consecutive fiscal quarters, some analysts
suggest this indicates that the U.S. economy was not in a recession at
the time. However this estimate has been disputed by some analysts
who argue that if inflation is taken into account, the GDP growth was
negative for the past two quarters, making it a technical recession.In a
May 9, 2008, report, the chief North American economist for
investment bank Merrill Lynch wrote that despite the GDP growth
reported for the first quarter of 2008, "it is still reasonable to believe
that the recession started some time between September and January",
on the grounds that the National Bureau of Economic Research's four
recession indicators all peaked during that period.
New York's budget director concluded the state of New York was
officially in a recession. Governor David Paterson called an
emergency economic session of the state legislature for August 19 to
push a budget cut of $600 million on top of a hiring freeze and a
7 percent reduction in spending at state agencies already implemented
by the Governor. An August 1 report, issued
by economists with Wachovia, said Florida was officially in a
recession.
White House budget director Jim Nussle said the U.S. avoided a
recession following revised GDP numbers from the Commerce
Department showing a 0.2 percent contraction in the fourth quarter of
2007 down from a 0.6 percent increase and a downward revision to
0.9 percent from 1 percent in the first quarter of 2008. The GDP for
the second quarter was placed at 1.9 percent below an expected
2 percent. Martin Feldstein, who headed the National Bureau of
Economic Research until June and serves on the group's recession-
dating panel, said he believed the U.S. was in a very long recession
and that there was nothing the Federal Reserve could do to change it.
In a CNBC interview at the end of July 2008 Alan Greenspan said he
believed the U.S. was not yet in a recession, but that it could enter one
due to a global economic slowdown.
A study released by Moody's found two-thirds of the 381 largest
metropolitan areas in the United States were in a recession. The study
also said 28 states were in recession with 16 at risk. The findings were
based on unemployment figures and industrial production data.
It is important to point out that in March of 2008, Warren Buffett
stated in a CNBC interview that by a "common sense definition", the
U.S. economy is already in a recession. Warren Buffet has also stated
that the definition of recession is flawed and that it should be 3
quarters of GDP growth that is less than population growth. However,
the U.S. only experienced two consecutive quarters of GDP growth
less than population growth.
Rise in unemployment
On September 5, 2008, the United States Department of Labor issued
a report that its unemployment rate rose to 6.1%, the highest in five
years. The news report cited the Department of Labor reports and
interviewed Jared Bernstein, an economist:
The unemployment rate jumped to 6.1 percent in August, its highest
level in five years, as the erosion of the job market accelerated over
the summer. Employers cut 84,000 jobs last month, more than
economists had expected, and the Labor Department said that more
jobs were lost in June and July than previously thought. So far,
605,000 jobs have disappeared since January. The unemployment
rate, which rose from 5.7 percent in July, is now at its highest level
since September 2003. Jared Bernstein, economist at the Economics
Policy Institute in Washington, said eight months of consecutive job
losses had historically signaled that the economy was in a recession.
"If anyone is still scratching their head over that one, they can stop,"
Mr. Bernstein said. Stocks fell after the release of the report, with the
Dow Jones industrials down about 100 points after about 40 minutes
of trading.

"Job losses are still mild by recession standards, but the losses are
relentless and they are accumulating," said Bob Brusca of FAO
Economics. "If job growth had paced with population growth during
this year, it would have meant 1.3 million new jobs would have been
created. Instead 605,000 were lost. That means about 2 million fewer
people are working than if the economy were on a steady path. And
that's a big number." But while economists generally study the payroll
numbers most closely, it's the unemployment rate that registers with
most Americans when they think about the labor market.

Liquidity crisis
In early July, depositors at the Los Angeles offices of IndyMac Bank
frantically lined up in the street to withdraw their money. On July 11,
IndyMac - the largest mortgage lender in the US - was seized by
federal regulators. The mortgage lender succumbed to the pressures of
tighter credit, tumbling home prices and rising foreclosures. That day
the financial markets plunged as investors tried to gauge whether the
government would attempt to save mortgage lenders Fannie
Mae and Freddie Mac. The two were placed into conservatorship on
September 7, 2008.
During the weekend of September 13–14, Lehman
Brothers declared bankruptcy after failing to find a buyer, Bank of
America agreed to purchase Merrill Lynch, the insurance
company AIGsought a bridge loan from the Federal Reserve, and a
consortium of 10 banks created an emergency fund of at least
$70 billion to deal with the effects of Lehman's closure, [37] similar to
the consortium put forth by J.P. Morgan during the stock market panic
of 1907 and the crash of 1929. Stocks on "Wall Street" tumbled on
September 15.
On September 16, news emerged that the Federal Reserve may give
AIG an $85 billion (£48 billion) rescue package; on September 17,
2008, this was confirmed. The terms of the rescue package were that
the Federal Reserve would receive an 80% public stake in the firm.
The biggest bank failure in history occurred on September 25 when JP
Morgan Chase agreed to purchase the banking assets of Washington
Mutual.
The year 2008 as of September 17 has seen 81 public corporations file
for bankruptcy in the United States, already higher than the 78 in
2007. Lehman Brothers being the largest bankruptcy in U.S. history
also makes 2008 a record year in terms of assets with Lehman's $691
billion in assets all past annual totals. The year also saw the ninth
biggest bankruptcy with the failure of IndyMac Bank.
On September 29, Citigroup beat out Wells Fargo to acquire the
ailing Wachovia's assets will pay $1 a share, or about $2.2 billion. In
addition, the FDIC said that the agency would absorb the company's
losses above $42 billion; in exchange they would receive $12 billion
in preferred stock and warrants from Citigroup in return for assuming
that risk.
Bailout of U.S. financial system
On September 17, Federal Reserve chairman Ben Bernanke advised
Secretary of the Treasury Hank Paulson that a large amount of public
money would be needed to stabilize the financial system. Short
selling on 799 financial stocks was banned on September 19.
Companies were also forced to disclose large short positions. The
Secretary of the Treasury also indicated that money market funds will
create an insurance pool to cover themselves against losses and that
the government will buy mortgage-backed securities from banks and
investment houses. Initial estimates of the cost of the Treasury bailout
proposed by the Bush Administration's draft legislation (as of
September 19, 2008) were in the range of $700 billion to $1
trillion U.S.dollars. President GeorgeW.Bush asked Congress on Sept
ember 20, 2008 for the authority to spend as much as $700 billion to
purchase troubled mortgage assets and contain the financial
crisis. The crisis continued when the United States House of
Representatives rejected the bill and the Dow Jones took a 777 point
plunge. A revised version of the bill was later passed by Congress, but
the stock market continued to fall nevertheless.