Global Financial Crisis: A Cheat Sheet

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The current global financial crisis we are witnessing is the first since the Great Depression of the 1930s in terms of severity. As each day passes, the situation seems to be worsening as global financial markets are plummeting and economies are facing the threat of recession. While we may not feel privileged to be witnessing these dire events, it is important that we are aware of how the crisis is developing as it is taking its toll on governments and individuals alike. However, not all of us are interested in the nitty gritty details, and require a straight-to-the-point break down. So listen up…

                                     

What happened?

 

Large financial institutions in the United States started to collapse, resulting in a number of European bank failures, which lead to a global crisis affecting banks and capital markets worldwide. The crisis has also lead to a liquidity problem.

 

The financial crisis started to manifest on September 14th, when the Lehman Brothers (a global financial-services firm based in the U.S) announced that it would file for bankruptcy. The same day also witnessed the sale of Merrill Lynch to the Bank of America. These events caused great anxiety among investors, causing them to lose some of their trust in the financial system, which was translated into global stock markets opening the week with sharp declines. On September 16, American International Group (AIG) (a large U.S insurance company), suffered a liquidity crisis following the downgrade of its credit rating. The U.S Federal Reserve ended up creating a credit facility for up to US$85 billion in exchange for a 79.9% share in AIG.

 

To-date, 8 U.S banks have been either fully or partly nationalized, 3 have been taken over, 2 have totally collapsed, and 1 is being aided with a rescue package from the government.

 

Why and how did it happen?

 

To understand the reasons behind the recent economic collapse, one would have to understand the financial systems currently at work. It is generally accepted that there are two main kinds of financial systems globally. A system based on banks and another based on capital/financial markets- which have recently proved its inefficiency. The latter, also referred to as the New Financial Architecture (NFA), a globally integrated system of giant bank conglomerates shadowed by investment banks, hedge funds and bank-created Special Investment Vehicles. Such institutions are often not regulated, according to the theory of efficient markets which stipulates that prices of traded assets, e.g., stocks, bonds, or property, already reflect all known information. Therefore, it is impossible to consistently outperform the market by using any information that the market already knows. Thus, the lacks of regulation has aided the growth of financial markets and also lead to their demise.

 

It is believed that the root of the crisis lay in the sub-prime mortgage crisis which occurred in the U.S. in 2007.

 

A housing market boom had accelerated in early-mid 2000s causing banks and mortgage brokers to push mortgage sales as they earned fees in proportion to the volume of mortgages they wrote. Banks earned large fees securitizing mortgages; selling them to capital markets in the form of mortgage backed securities (MBSs). Ideally little –if any- bank risk is involved this process, as banks distribute most of these mortgages to capital markets as asset-backed securities-that is they are backed by assets and have an actual value.

 

These asset backed securities gained popularity as they were given high ratings in addition to the fact that they yielded higher returns than equally rated corporate bonds. As demand for these products increased, banks and brokers began selling mortgages to people who wouldn’t be able to pay them which eventually lead to large defaults and what became known as the sub-prime mortgage crisis. This lead to an extended collapse in the financial system as mortgage-based financial products had been spread around the world.

 

How have governments reacted globally?

 

Measures have been recently taken to ease the credit crunch and increase liquidity. Six of the world’s main central banks announced simultaneous emergency interest rate cuts by 50 basis points. These banks are the US‘s Federal Reserve, the Bank of Canada, the Bank of England, the European Central Bank, Sveriges Riksbank and the Swiss National Bank. The Bank of Japan kept rates on hold, although it has pumped $29.3 billion into the financial system on September 17. A number of Asian countries (including China) also cut rates.

 

GCC countries have to follow US rate cuts to some degree as their currencies are pegged to the USD. Bahrain, Kuwait and the UAE have cut interest rates in response to the 50 basis point rate cut by the US Federal Reserve, and the UAE has also pumped USD 19bn into the banking sector in order to ward off any undesired ramifications.

 

Outlook

 

The matter of the fact is that, there can be no future outlook at this point in time as events are still unfolding. However, many opinions are actually pointing out that the current financial crisis can be an opportunity for emerging markets that could provide excellent investment opportunities for investors who wish to keep their money away from the financial system in the time being. So, all we can do is wait and see.

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