the financial crisis and its impact to the us economy-finalv

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Key factors leading to the global financial crisis of 2008/10 and its

impact on U.S. economy

Assignment work

International Business in Focus

Academic year: 2010 / 2011

Module Lecturer: Dr. Greg O´Shea

Author: Glenn Moeller

Student ID: 1021901

Due Date: Monday 13th

December 2010 by 5pm

Study Program: Visiting Student Abroad (AIBS) Germany

2,991 words



Financial c isis of 2008

¡

10 and its impact on U.S. economy

II

Table of Contents Table of Contents................................................................................................................II

List of Figures.....................................................................................................................III

List of Tables......................................................................................................................III

List of AbbreviationsIII

1. Introduction................................ ................................ ................................ .................... 0

2. Analysis of Key factors and its impact on U.S. economy ................................ .................... 1

2.1 U.S. Financial Sector ................................ ................................ ................................ ................. 1

2.1.1 Reasons for selling credit claims................................ ................................ ......................... 3

2.1.2 Role of SPEs during the financial crisis................................ ................................ ................ 4

2.1.3 Maturity transformation ................................ ................................ ................................ .... 4

2.2 Actual Development of the US financial market ................................ ................................ ........ 7

2.2.1 Reactions of the FED ................................ ................................ ................................ .............. 7

2.2.2 Depreciation of U.S. banks and companies................................ ................................ ......... 7

2.3.1 Fear of Recession ................................ ................................ ................................ ............... 9

3. Conclusion ................................ ................................ ................................ ....................... 12

References List ................................ ................................................................ ................... XIII



Financial crisis of 2008¢


III

List of Figures

Figure 1: U.S. Foreclosure Rates 1979 until 1st Quarter 2008............................................ .......3

Figure 2: Process of Loan Transformation................................................................................. 6

Figure 3: U.S. Interest Rates and Inflation................................................. ..............................11

List of Tables

Table 1: U.S. Economic Statistics............................................................... ..............................10

List of Abbreviations

ABCP Asset Backed Commercial Paper

ABS Asset Backed Securities

Anon. Anonymous

BaFin German Federal Financial Supervisory Authority

CDO Collateralized Dept Obligation

E.g. Example given

FAZ Frankfurter Allgemeine Zeitung

f.e. For example

FED Federal Reserve

HGB German Commercial Code

IFRS International Financial Reporting Standards

MBS Mortgage Backed Securities

n.d. no date

NINJA No Income, no Job, no assets

OECD Organisation for Economic Cooperation and Development

S&P 500 Standard & Poor`s 500

SIV Structured Investment Vehicles

SPE Structured Purpose Enterprise

U.S. United States

WISU Magazine Das Wirtschafts Studium



1. Introduction

´Crises are part of the capitalist system as the sin of religion´ (Schnabel & Hoffmann, 2007)

The News is still dealing with the Financial Crisis nowadays. Nearly every day on any

TV-channel appear some messages concerning the development of the US-Economy

and there is no end in sight. The reason therefore is the real estate crisis in the

United States. Its origin had the Crisis a f ew years ago regarding the booming Real

Estate Market in the US. Most of the American could not afford their own home, but

doing to lucrative off ers from the banks the temptation was too high in most of

the cases. The property market had a long-term increase in sales figures and prices

rose constantly.

After the often variable agreed interest rates raised parallel to the general held boom

and towards all expectations the real -estate prices were fallen, most of the debtors

were unable to handle their credits. Foreclosures in an unprecedented number and

Depreciations in billions were the result. The growing number of personal

bankruptcies as well as the highly losses had an enormous impact on the economy.

The Economic growth stagnates, consumption falls and recession f ears rise. This

assignment explores the Financial Crisis causes from its beginning and shows the

resulting eff ects on the American economic sectors Banks, Companies, Consumers and the Economic.



Financial crisis of 2008£


1

2. Analysis of Key factors and its impact on U.S. economy

2.1 U.S. Financial Sector

The real-estate crisis extended onto the Banking Sector. Since 2009 a f ew financial

institutes, which specializes in granting of mortgage loans for debtors with low credit

ratings. In order to investigate the cause a review during the last five to eight years of

the real estate and financial market is required. During the year s 2000 / 2001 the New Economy Bubble busted on the stock market, partly influenced by the terrorist

attacks of September 11th. That was the time when the global economy began to fall

into a recession. (Fischer, 2007)

To avoid this and to stabilize the US Situation, the former chief of Federal Reserve,

Alan Greenspan has lowered the key interest rate down to a percent. The rates were

kept low due to continuing deflation f ears although the economy has recovered. This

has triggered a global credit expansion. (Fels, 2008) The U.S. citizens have been lured

to buy and a new form of loans was created. Without evidence of equity they were

suddenly able to borrow credits and to buy their own home. The loans were not

audited usually with lesser credit ratings assigned. These credits are called Subprime

or Ninja Credits (No Income, no job, no assets). The credit conditions included for

the first two to three years, low fixed interest rates. For subsequent years variable

interest rates have been agreed, which were usually much higher. This development

led to high indebtedness of many households. Further, the debt exacerbated by the

fact that many U.S. citizens, driven by the projected value of their homes, this new

addition have loaned to the cars, vacation trips or more houses than to make objects

of speculation. With increasing demand for real estate also increased their prices.

This has raised the value of the property as collateral an d became much more

attractive. (Anonymous, 2007)



Financial crisis of 2008/10 and its impact on U.S. economy

2

The banks have speculated on that housing prices in the U.S.¤

ould continue to rise.

Therefore ¥ many banks offered a 100 percent to 110 percent home- financing. But

development took a different course. TheU.S. central bank had since mid-2004 the key rate

to 4.25 percent points increased and thus the prime rate then¤

as 5.25 percent. For many

Households this step¤

as crucial because the loansas already mentioned above¥

¤ ere no

¤

converted to variable interest rates. Many U.S. citizens¤

ere thus notrepaying their loans

and conse¦

uently there¤

ere loan defaults and foreclosures. From 2000 to 2006, loans

amounting to about 1.2 trillion U.S. dollars a¤

arded. It is estimated that about 300 up to $

400 000 000 000 of these loans are so-called "risky loans". (Hemmerich, 2008)

Fi§

u

©

1: U.S. Fo

©

losu

©

s Rat©

(Mo

t§

age Bankers Asso

iation, 2008)




3

2.1.1 Reasons for selling credit claims

To avoid these risky loans on their balance sheets, the mortgage banks have exposures this

claims to other U.S. Financial Institutions, mostly Investment banks. According to

Hemmerich, there are three main reasons why the mortgage banks have sold the loans

rather than to keep them on their own:

First, the banks want to continue growing through the new lending. To make this possible

they have to refinance, which means they have to raise new money to grant further loans.

Secondly, the banks have already since January 01st, 2007 - after the implementing the EU

Directives 2006/48/EC (Directive Bank) and 2006/49/EC (CRD) in Europe to hold usually 8

percent of the granted loans as equity. Thus, the allocation of new Credit is limited. If the

banks sell their loans, those will be removed from its balance sheet. The banks are thus in

able to grant new loans. The U.S. had the Basel II negotiation on the minimum capital

requirements originally proposed its implementation but now postponed to 01/01/2009.

Thirdly, the banks have a way despite the sale of receivables found to make money. The sale

of credit receivables to third parties, the bank usually loses its interest margin.

(Hemmerich, 2008)




4

Interest margin is defined as "(...) a diff erence between two interests rates, particularly

between the debit and credit interest rate in bank holdings. There are Interest income and

interest expense to business volumes placed in relationship." (Alisch, 2004) An interest

margin of one percent is already very interesting for a bank. To keep the interest margin,

nevertheless, the banks had to sell the loans to special purpose entities. These SPEs were

established for this purpose usually of the mortgage banks or an investment bank.

2.1.2 Role of SPEs during the financial crisis

A major role in this financial crisis play the SP E´s, which are called conduits or SIV (Structured

Investment Vehicles) and particular operating in maturity transformations. These companies

primarily invest in longer-term bonds with high interest rate. "As a conduit structure is called

a refinancing, which means special purpose vehicle requirements such as, for example, long-

running loans, trade receivables or externally rated securities in one or revolving behaviour

and refinancing on the issue of money market paper in an international currency".

(Scherer & Bosak, 2007)

2.1.3 Maturity transformation

The so-called transition period was the solution for the mortgage banks to retain their

interest margin. Property loans are usually long-term loans with terms of 10-15 years. These

loans subject to a high risk and therefore represent a high Interest rate paid. With the help

of the period of transformation, these purpose vehicles had been able to convert long-term

Loans into short-term Loans. A long-term loan at an interest rate, for example 6 percent, had

been turned into a short-term Credit with e.g. 4 percent interest rate by the SPV´s and then

gave it further. After a year for instance, the short-term loans were repaid and a new short-

term credit awarded. In this way the banks, together with the SPV´s could refinance




5

themselves and could kept the Interest margin in the real estate loans, although these loans

ere sold. They refinanced over short-term bonds of 4 percent and then received the bond

of the mortgage loan for e ample by 6 percent.

The long-term loans

ere put together in so-called demand packages. Large packages could

claim thousands of bank loans in si -digit dollar amounts from different banks including

these loans, consisted of loans hich ere held by Debtors ith both, good and bad credit

rating. Most

ere such packages put together so comple

, that it is difficult to recognize the

relationship bet

een the "good" and "bad" loansto each other. The S

s have their o

n

securities (bonds) created (Securitization) to finance the debt packages and they have sold

them in the capital market. Among them ere AB Ps (Asset-backed commercial paper) that

a short term (e.g. fe Days) and have ABS (Asset Backed Securities) hich have an average

maturity (less than t

o years). These bonds

ere secured by assets (Assets e.g. mortgages).Such ABS by mortgages assured, the MBS (Mortgage Backed Securities) are cited.

Together these structures revealed an ABS CDO (Asset Backed Securities Collateralized Debt

Obligation). These,

ith attractive interest rates inflated, CDOs

ere sold to different

investors (e.g. hedge funds, private individuals, banks,and Insurance or pension funds)

orld

ide. (Laing & Sch

indel, 2007)Thus this emerging financial crisis has escalated into a

global international Problem. Figure 1 sho s the above-described Facts.

Because of the comple ity of the packages, buyers could not claim the different credit

ratings,

hich

ere included in the packages. Conse

uently, they gave a great importance to

the opinion of rating agencies set,

hich valued mostly bonds as AAA-rated. Crucial for the

good rating by the rating agencies

as that the Banks as o

ners of special purpose entities,

also called sponsors, appropriate li

uidity guarantees promised. This, as the banks could

take the risks out of their balance sheet, because the purpose vehicles made outside the

Figure 2: Pro

ess of Loan transformation (Hemmeri

h, 2008)




6

balance sheet and thus out of the banking supervision. The assets of the banks and special

purpose vehicles were strictly separated, e.g. that the SPEs were protected from the

financial problems of the sponsors. Thus, banks were required by the special purpose

entities to purchase commercial paper issued when the investors would not buy them. This

exact scenario has arrived: The owners of the commercial paper were suspicious and refused

to follow-on investments. (Franke & Krahnen, 2007)

Thus, the purpose vehicles ran into difficulties and the Owners (banks) had, as contractually

agreed, to pay for them. The aff ected banks were in such a situation they could not prepare

for and the risks have been underestimated. The liquidity guarantees grant may have been

the sponsors forced new loans record. The lending institutions were therefore sceptical been

refused and demanded money market loans or high interest rates. It came to a breach of

confidence among banks. This was on the lack of transparency and lack of Bank regulation inthe banking system.

The purpose entities are not consolidated in the balance sheets and thus are those of the

Bank risk-taking is not visible from outside the type and scope.

Consequently, other banks were suspicious and f eared that granted loans would not been

repaid. According to the IFRS (International Financial Reporting Standard) recently stricter

consolidation rules are for example according to German Commercial Code (HGB), the

special purpose companies still do not balance sheet to consolidate. Thus, it was easy for

banks dealing with no major problems to manage the risks and to disguise it in order to

provide cheaper money. (Scherer & Bosak, 2007)




7

2.2 Actual Development of the US financial mar et

2.2.1 Reactions of the FED

Until summer 2006, peak prices in the property market achieved. Then the housing bubble

busted and there was oversupply to homes in the U.S. housing market. Real estate prices

began to fall. The properties as collateral for mortgage loans therefore lost its value. The ex-

chief of the Federal Reserve, Alan Greenspan assumes that house prices will fall even

further. Depending on how the property prices continue to develop , it impacts the global

economic fate. To prevent the risk of recession and the spread of the crisis, the U.S. Federal

Reserve lowered key interest rates again. To keep the banking system liquid, the central

bank pumped at short notice cash injections of about 24 billion U.S. dollars into the financial

market.

In addition, it was decided by the central bank that no longer only commercial banks but also

investment banks in Fed can refinance. (Anonymous, 2007)

2.2.2 Depreciation of U.S. ban s and companies




8

The financial crisis has aff ected several banks serious, since at the banks concerned there

have been large losses. Worldwide the banks have now about 130 billion dollars of so -called

"bad" Loans written off. In the 3rd and 4 Quarter of last year there were at the Citigroup

write-downs of over $ 24,600,000,000, at Merrill Lynch in the same period there were 23.6

billion U.S. dollars and the Bank of Ameri ca had to write off 5.3 billion U.S. dollars. At UBS

Depreciation amounted to 14.4 billion U.S. dollars. An end still does not seem to be in sight.

The rating agency Standard & Poor's still expected late last year with up to 265 billion U.S.

dollars depreciation overall. (Anonymous, 2008) The tendency of the related Estimates

increases. The German Federal Financial Supervisory Authority (BaFin) estimates in the worst

case, now with a Sum of $ 600 billion write -downs of American Banks. In early April 2008,

already 295 Billion dollars losses has been admitted officially from U.S. banks, of which

about 10 Percent belong to German institutes. (Anonymous, 2008) "The amount of depreciation on so-called sub-prime securities, so products based on inf erior American

mortgage debts based shall do according to how far hous e prices fall in the U.S."

(Schieritz & Storn, 2008) , said Jochen Sanio, President of the BaFin in an interview in April in

German newspaper "Time".

2.3 Impact on U.S. Businesses

The global crisis is already showing its impact on the various Industries and is significant for

individual companies. These eff ects are visible in the results of the large Corporations.

According to expert forecasts, the profits of the 500 largest U.S. co mpanies expected to

decline significantly. Declining Earnings forecasts exists as well for European companies.

Particularly strong impact shows the crisis in the financial sector. Expectations go up until 60

percent decline in profits. In addition to the b anks suff er particularly cyclical consumer goods

companies, as the private consumption Households indicates a reticent behaviour. As the

calculations of the Financial Services Thomson Financial shows, the gains in U.S. consumer

goods are going too shrunk by 10 percent. (Eberle, 2008) But the other Industries are also

struggling with bad quarterly figures. The aluminium producer Alcoa had in the 1st Quarter

compared to the prior year quarter report a profit decline of 52 percent. CEO Alain Belda

claimed that - in addition to the eff ects of the credit crisis the profit slump may attribute to

increases in energy and commodity prices and the weak dollar. (Anonymous, 2008) Taken

heavy from the consequences of the financial crisis is also the world's largest U.S.

conglomerate General Electric. CEO Jeff Immelt acknowledged recently that the figures for




9

the year 2008 will be disappointing. Shrinking profits had been reported in the 1st Quarter,

which impacts the annual forecast negatively. (Anonymous, 2008)

The biggest f ear is that the credit crisis already reached the real economy, and slows down

many businesses. The first quarter is the third in a row in whi ch profits of the S & P 500

(Standard & Poor's 500)-listed companies decline. Analysts give the financial industry's fault.

In technology and supply industry, as well as energy, healthcare and telecom industries

further increase in profits are forecasted. (Lange, 2008) Banks has become more cautious

with lending loans. Thereby industrial investments return accordingly. This expected to have

a negatively aff ect on the economic growth in the coming Quarters.

2.3.1 Fear of Recession

The economy of the strongest economic power, which generates about one-fifth of the

annual world income, has since the financial crisis in mid -last year, repeatedly experienced

burglaries. In 2007, the Economy weakened compared to previous years, but still increased

for the whole year by 2.2 percent. However, it is the weakest growth sin ce the terrorist

attacks 2001.

There are already signs now that the U.S. economy for the full year 2008 stands still

significantly worse. In early March, the organization of the rich countries - OECD has

2007 2006 2005

GDP nominal (Bill. USD

13,843 13,195 12,434

GDP real growth 2,2 % + 2.9 % + 3.1 %Unemployment rate 4,6 % 4.6 % 5.1 %

Consumer Prices 4.1 % + 2.5 % + 3.4 %Table 1: U.S. Economic Statistics (Department of Commerce 2008

!




10

published the forecast that it is in the first half of 2008 come to "zero growth" and many

economists mentioned since the beginning of the year again recession f ears. If there would

be a shrinking U.S. economy, it would have serious consequences for the entire world

economy because U.S. is the largest Import land. (Brost, 2008) America consumes more than

it produces.

The real estate crisis impacts the confidence of the people, the labour market and bank

lending still significant, with the Result, households cut back their consumption and planned

postpone purchases. Also, business investment for machinery and equipment continue to

fall. For the further development however, private consumption is mainly critical. It accounts

for nearly 70 percent of gross domestic product of the USA. Three Factors aff ecting

consumer spending currently: the declining House prices to fall and in some cases falling

share prices of assets, rising unemployment, reduced income growth and the rising energy prices cause real income losses. If the economy weakens further, losses on loans and

corporate bonds are going to increase.

To counteract the risk of recession, the U.S. Federal Reserve, under headed by Ben

Bernanke, since the crisis began August 2007 to present , lowered its key rate seven times in

a row, a total of 3.25 Percentage points to 2 percent lower, pumping liquidity into the

market, (Anonymous, 2008) because the Fed is required by law for monetary stability and to

attend the high employment. In September last Year, it lowered - for the first time since June

2006 - interest rates by 50 basis points from 5.25 to 4.75 percent, followed by 25 basis

points to 4.5 percent in late October 2007 and mid -December to 4.25 Percent.

Further rate cuts became necessary through the bleak economic outlook in January 2008.

The Fed lowered the interest rates within a week by 75 basis points from 4.25 to 3.5 percent

and a short time later by another 50 basis points to 3.0 percent. (Anonymous, 2008)

The recent reductions to date in mid-March at 75 basis- points in late April and again by 25

points to 2.0 percent now.

A further cut in interest rates, as after the bursting of the high-tech bubble a f ew years ago

to 1 percent - even if the economy should continue to shrink is rather unlikely.




11

If it lo"

ers its key rate, commercial banks also re#

uires lo"

er Interest. This stimulates

consumption and investment, animated stock prices and devalues the currency. The

economy is stimulated. Interest Rate Cuts ho" ever, must be undertaken " ith caution,

other"

ise rising inflation due to cheap money, as money devalues and provoke failures at

the financial markets. (Schieritz, 2008) With each interest rate cut the Fed increases the risk

of inflation.

As a further measure against a potential recession, Democrats and Republicans in Congress

in January 2008 agreed on a comprehensive economic stimulus package of over $ 150 billion

that corresponds about 1 percent of U.S. gross domestic product. The Package provides for

more than 117 million U.S. families from ta$

refunds each of at least 300 dollars and

investment incentives before. In addition to in distressrated trends homeo"

ners

recapitalisations be facilitated. (Schmiester, 2008) If the U.S. households on the economic-

emergency program and ignited the resulting ta$

refunds could spend,the U.S. also bring

back ne"

life into the"

orld economy.

Figure 3: U.S. Interest Rates and Inflation (Federal ReserveBoard, 2008)




12

3. Conclusion

This Essay has shown that the housing crisis has signed off for years. The market was slow

out of control advised: Real estate financier forgave loans without checking their customers

credit ratings, rating agencies awarded frivolous labels of quality and banks managed billion

risks outside its balance sheet.

The greed for profit and power let them miss it to initiate countermeasures, which would

have been likely to prevent the development of a global financial crisis. After the self-healing

Market had failed, only temporary, quick intervention of the Central Banks could hold a

"financial meltdown" away.

This can flare up again controversy whether a State intervention and the use of taxpayers'

money in crisis situations should be justified.

Despite all this billion Depreciation from the banks, massive foreclosures from homes and

the massive job cuts could not be prevented.

The crisis has shaken investors confidence strong. To recover it, the need to produce

substantial improvements in the entire financial system is one of the most important issues.

Consensus exists at the points of transparency, risk management and banking regulation.

The self-imposed code of conduct of the banks is a first step in the right direction. For this




13

has success, consistent and constant review of compliance is inevitable. For the future, the

financial world should know that an early prevention of such a crisis includes much lower

losses, than to eliminate a country in ruins after the event.

This requires an early recognition of dangers ahead by experts so that appropriate measures

can be taken.

It remains to be seen how the financial crisis is going to develop furthermore. Currently it is

not yet clear in which direction it moves. Both extremes appear even possible: The

escalation of the crisis, as well as their soon end.

"You must hold up a mirror to the world of finance. It has

disgraced powerful. And a clearly audible mea culpa miss

I still. Only a capitalism that is ready to be the responsibility

to bind a future. " (Vornbäumen, 2008)

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'

(

W )

(

0

1

2 haf

0

1

&

' x

)

3

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7 ä

8

9

@

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IV

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