The Global Financial Crisis of 2008-2009 Case Study



The Global Financial Crisis of 2008-2009 Case Study

Introduction

The 2008 global financial crisis has highlighted the limitations of our current financial theory and models. It was the most severe crisis since the Great Depression of the 1930s, yet few financial economists saw it coming. What started as a meltdown of the U.S. subprime mortgages in 2007 quickly spread to the U.S. financial sector and grew into a full-blown global banking crisis following the collapse of Lehman Brothers and Washington Mutual in 2008. The asset liquidity vanished, asset prices fell drastically, and financial market volatility jumped to unprecedented levels. The impact of the crisis varied widely across geographical regions and even across countries within regions.

Discussion

As the crisis deepened, most financial institutions experienced significant losses in their trading books that arose from credit migrations, widening credit spreads, and evaporating liquidity. To deal with this issue, the Basel Committee on Banking Supervision increased the capital requirements for banks' trading books by introducing an Incremental Risk Charge (IRC).

Many firms lost more than three-quarters of their stock market value did. Under the auspices of the Federal Reserve, JP Morgan Chase acquired Bear Stearns and Washington Mutual; Bank of America acquired Countrywide Financial and Merrill Lynch; Wells Fargo bought Wachovia; and Goldman Sachs, Morgan Stanley and American Express converted into bank holding companies. A total of 22 of the 47 firms received capital injections under the US Treasury's Troubled Asset Relief Program. The government took over Fannie Mae and Freddie Mac (95 percent of US mortgages are now channeled through government institutions.). The bankruptcy of Lehman Brothers was especially traumatic. One reason it had such wide-ranging effects was that it contradicted the idea that the main banks were too big to fail (Nouriel, 2010).

The mortgage market became a huge source of toxic assets. The bankers bundled good debt with bad debt and sold the securities to the world. The rating agencies, Moody's, Standard & Poor's (S&P) and Fitch, attached triple-A ratings; as if there was zero credit risk (They had been intimately involved in the creation of the securities, e.g. the composition of pools of loans.). In retrospect, the ratings look like a deliberate fabrication (Yet, the conflict of interest was always in plain view.). At first, debt investors had faith that the likelihood of losses was low. Only after disaster struck did they find out the truth. Hundreds of billions of triple A rated mortgage-backed securities (MBSs) and collateralized debt obligations (CDOs) proved anything but bulletproof. A big chunk of the subprime debt ended up in Western Europe and in oil-exporting countries, causing massive write-offs (Fischer, 1999).

In October 1939, Winston Churchill said that “Russia is a riddle, wrapped in a mystery, inside an enigma.” Perhaps, that quote can be profitably recycled as we analyze the details of the contemporary world economic crisis, a breakdown of a magnitude not seen since the Great Depression. The crisis, still in progress, has been blamed on so many causes that it ...