Preented by:

Outline of the Presentation

y What is Recession? y What is Financial Crisis? y The Genesis of the current y y y y y y y y Effects on Pakistan y Current scenario across the globe y Alternative View

problem y Conclusion Impact on US Causes of Sub-Prime Crises Economic Imbalance Impact of the Crises What did Goverments do? Effects on Developing Countries Role of G-20 in solving financial crises

What is Recession?
A recession is defined as a period of time when the economy contracts (negative economic growth) for 2 consecutive quarters. A recession is characterized by y Lower Output y Lower investment y Higher Unemployment y Increased PSNCR (Public Sector Net Cash Requirements) y Lesser Economic Growth

What is a 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.
y In the past financial crises have been generated by combination of factors such as :
y y y y y y y

Overshooting of markets Excessive leveraging of debt, and credit booms Miscalculations of risk Rapid outflows of capital from a country Unsustainable macroeconomic policies Inexperience with new financial instruments, and Deregulation without sufficient market monitoring and oversight.

WHAT HAPPENED?
Low interest rates, high leverage and overconfidence led to the creation of bubbles which then burst.

y It all started a decade back with a booming housing market in

America.
y The boom was later fueled by expansion of liquidity in the system in

the form of Mortgaged backed Securities and Collateralized Debt Obligations (CDO) invented by Wall Street.
y In the first few years there was just too much demand for all

Investment Grade properties.

Effective Federal Funds Rate, June 1954 - Jan 2010

Interest Rates have gone from 2% to 20% and then down to 0.12%, They have nowhere to go but up now..
20

15

10

0
1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015

Fed Funds Rate

Source: Federal Reserve Board of Governors

Sub-prime Mortgage Crisis

y Mortgage brokers and Mortgage Lenders were more than happy to

look for anybody and everybody who wanted a mortgage (Which in simple terms means home loan).
y In Initial few years boom was observed in American Housing Market

because of Subprime Lending and CDOs. Between year 2002 and 2006 property price was increased by almost 40% .
y In case of Subprime Lending no one is taking enough care to see the

repayment capacity of borrower, in some cases even margin money was waived off.
y This was a perfect foundation for disaster. Equity was scarce and

short in supply.

y The value of CDO started going downward. It was unable to pay

neither the capital nor the returns.

y During the year 2007, the balance sheet and profit account of

investment bankers, banks & financial institutions was favorable and running the ride of optimism. This helped banks inflate their earnings and profit forecasts, and in turn their valuations.
y Bankers started leveraging their own banks in stock market. A close

look at the leverage ratio of top 5 banks in US tells that it was an all time high during years 2003-2007.
y Higher the leverage ratio, higher is the default risk. If any bank is

leveraged by 10 times, positive change of $1 can bring $10 profit but negative change of $1 can bring $10 loss. With greed increasing day by day, people were making irrational judgments.

y People were buying as if there was no tomorrow. In year 2005,

boom in economy was halted. In year 2006, there was marginal increase in property prices.
y In Year 2006, Fed has increased its Interest rate which in turn

affected lending rate of subprime loans.

y As interest rate shoot up, borrowers started defaulting, which

resulted in increased supply and reduced prices.

y Contraction of liquidity means no aggressive lending, which in

turn affected rollover of existing leverage .

y This caused downward spiraling effect on stock price.

y The immediate cause or trigger of the crisis was the bursting of

the United States Housing Bubble which peaked in approximately 2005 2006. mortgages (ARM) began to increase quickly thereafter.

y Already-rising default rates on subprime and Adjustable rate y However, once interest rates began to rise and housing prices started

to drop moderately in 2006 2007 in many parts of the U.S., refinancing became more difficult.

y As housing prices declined, major global financial institutions that

had borrowed and invested heavily in subprime MBS reported significant losses. loan.

y Falling prices also resulted in homes worth less than the mortgage

Source: Bloomberg

US Housing Bubble

IMPACT ON US
y Housing prices dropped 20% from their 2006 peak. y 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.
y The banks declared bankruptcy which led to layoffs and thus the unemployment level reached its peak during 2008. y Unemployment led to decrease in demand, thus suffer losses which again compelled firms to decrease the number of employees and thus US entered into a vicious circle.

y By early November 2008, the S&P 500 was down 45% from its 2007 high. y Losses in retirement assets, savings, investment assets and pension assets suffered huge losses up to $8 trillion. y By the end of August 2008, various financial firms around the world have written down their holdings of subprime related securities by US$501 billion. y By 2008 more and more financial firms either merged, or announced that they were negotiating seeking merger partners.

Change in US Real GDP, 1948-2009

This has been the worst downturn since end of World War II
15 Percent (%) Change

10

-5
1949 1954 1959 1964 1969 1974 1979 1984 1989 1994 1999 2004 2009 2014

Growth Rate

Source: Bloomberg

Causes of Sub-Prime Crisis

y Boom And Bust In The Housing Market:
y The housing bubble that burst caused a negative wealth affect on

the market as people began to panic and the situation rapidly deteriorated on the face of falling market prices.
y High-risk Mortgage Loans And Lending/Borrowing Practices:
y Credit ratings were manipulated to reduce the risk levels of the

mortgages by combing numerous securities in one large group known as MBSS (Mortgage Backed Securities). This had the affect of effectively hiding the risk factor of the loans and allowing banks to sell them off to investors.

y Inaccurate Credit Ratings: y Credit ratings were being assigned by credit rating firms that were in private hands, these firms were being paid by banks and in order to continue a good relationship with their clients. Low level risk ratings were assigned to the special investment vehicles (SIVs) the banks were using. At one point Moody had 40% of its income coming from the inflow of such credit rating activities. y Government Policies: y Extremely low interest rates, de-regulation and giving credit rating authority to the private sector. y Boom And Collapse of the Shadow Banking System: y The shadow banking systems were the mutual funds and their like that played an important role in providing funds to corporations and other enterprises, however, they lacked the regulation and oversight of the banking industry.

Economic Imbalance
y Commodity Boom: y The decade of the 2000 s saw a global explosion in prices, focused especially in commodities and housing, marking an end to the commodities recession of 1980-2000.
y

In 2008, the prices of many commodities, notably oil and food, rose so high as to cause genuine economic damage, threatening stagflation and a reversal of globalization. In January 2008, oil prices surpassed $100 a barrel for the first time, the first of many price milestones to be passed in the course of the year. In July 2008, oil peaked at $147.30 a barrel. 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.

y y

Source: Bloomberg

Source: New York Times

y Trade:  In mid-October 2008, the Baltic Dry Index, a measure of shipping volume, fell by 50 per cent in one week, as the credit crunch made it difficult for exporters to obtain letters of credit. y Unemployment: y The International Labour Organization predicts that at least 20 million jobs are likey to be lost by the end of 2009 due to the crisis mostly in "construction, real estate, financial services, and the auto sector" bringing world unemployment above 200 million for the first time.

y Inflation:
y In February 2008, Reuters reported that global inflation was at historic

levels, and that domestic inflation was at 10-20 year highs for many nations.
y Excess money supply around the globe, monetary easing by the Fed to

cultivated financial crisis, growth surge supported by easy monetary policy in Asia, speculation in commodities, agricultural failure, rising cost of imports from China and rising demand of food and commodities in the fast growing emerging markets.
y Inflation was also growing in countries classified by the IMF as "non-oil-

exporting LDCs" (Least developed countries) and "Developing Asia", on account of the rise in oil and food prices.
y The price of gold rose by 30% from middle of 2007 to end of 2008.

y War:
y The recent wars in Afghanistan and Iraq have had a significant

role to play in the causes of the current economic recession.

y A current estimate of the total cost of the war is $1.6 trillion by

the end of 2009

y Massive U.S government borrowing that contributed heavily to

the debt burden of the government and reduced money supply

y At the same time it also added an atmosphere of uncertainty to

the Middle East causing fears of disruption to the oil supply and increasing price levels.

Impact of the Crisis

y Collapse of Financial Institutions in several parts of the world y Lehman Brothers; AIG, Freddie Mac and Fannie Mae etc. y Central Banks in vulnerable countries such as Iceland become Bankrupt y Investors across the globe lost huge amount of their investments y Severe Credit squeeze and Liquidity crunch for the industry y Housing; Automobiles; Retail; Services etc.

Scale of the potential bailout (already up to $850bn)

Net foreign investment in the United States (1993 2009)

Financial Crisis On Stock Market

Stocks lowest since 9/11
y The Dow industrials dropped 504.48 points to close at 10,917.51, the first time since July it s finished under 11,000. y It was the sixth-largest point drop ever and the worst since Sept. 17, 2001, when the average fell 684.81 points on the first day of trading after the terror attacks. y Broader stock indicators also fell. y The Standard & Poor s 500 index lost more than 4 1/2 percent, and the Nasdaq composite index lost more than 3 1/2 percent.

The End Of The Stock Market Boom....

Source: Economist Dec, 2008

What Did Governments Do?

Intervened in order to prevent a systemic collapse and an economic depression.

Governments responded swiftly and decisively to save the system Central banks stepped in and provided liquidity to the banking system allowing it to keep functioning Expanded the money supply Governments provided bailouts for major financial institutions to avert their collapse or took them over outright Governments also cut taxes and raised spending to prevent the economy from falling into a deep recession or even depression

Effects on Developing Countries

y Trade And Trade Prices:
y Growth in China and India has increased imports and pushed up

the demand for copper, oil and other natural resources, which has led to greater exports and higher prices, including from African countries. Eventually, growth in China and India is likely to slow down, which will have knock on effects on other poorer countries.
y Remittances:
y Remittances to developing countries will decline. There will be

fewer economic migrants coming to developed countries when they are in a recession, so fewer remittances and also probably lower volumes of remittances per migrant.

y Foreign Direct Investment (FDI) And Equity Investment: y These will come under pressure. While 2007 was a record year for FDI to developing countries, equity finance is under pressure and corporate and project finance is already weakening. The proposed Xstrata takeover of a South African mining conglomerate was put on hold as the financing was harder due to the credit crunch.

y Commercial Lending: y Banks under pressure in developed countries may not be able to lend as much as they have done in the past. Investors are increasingly, factoring in the risk of some emerging market countries defaulting on their debt, following the financial collapse of Iceland. This would limit investment in such countries as Argentina, Iceland, Pakistan and Ukraine.

y Aid:
y Aid budgets are under pressure because of debt problems and weak

fiscal positions, e.g. in the UK and other European countries and in the USA. While the promises of increased aid at the Gleneagles summit in 2005 were already off track just three years later, aid budgets are now likely to be under increased pressure.
While the effects will vary from country to country, the economic impacts could include:

Weaker export revenues Further pressures on current accounts and balance of payment Lower investment and growth rates Lost employment There could also be social effects Lower growth translating into higher poverty

Worl

onomi
rowth

rowth,

nd rojections for

&

ercent (%)

8 7 6 5 4 3

-3 -4 3 4 5 6 7 8 World Average

Advanced Economies

Emerging Economies

Source: IMF WEO Update, January 6,

Declaration of the Summit taken place in November 2008:

1) To enhance cooperation among the nations and work together to restore global growth and achieve needed reforms in the world's financial systems. 2) Lay the foundation for reform to help to ensure that a global crisis, such as this one, does not happen again. 3) To ensure that market principles, open trade and investment regimes, and effectively regulated financial markets foster the dynamism, innovation, and entrepreneurship that are essential for economic growth, employment, and poverty reduction.

Impact on Pakistan
y Capital Flows and Workers Remittances:
y A stressed international economic environment has held back

Foreign Investment as it posted a decline of 47.5 per cent during the first ten months of 2008-09 unaffected by the crisis, totaling US$ 6.36 billion in July-April

y Workers remittances to Pakistan remained vigorous and

y Commodity Prices and Trade:

y An unprecedented hike in international commodity prices wreaked

chaos on Pakistan s external sector during 2007-08, with the current account widening significantly.

y However, in the wake of a reduction in global demand and the

resultant decrease in commodity prices, the import bill has reduced significantly, decreasing the current account deficit

y External Financing:
y The global crisis has restricted Pakistan s ability to tap the

international debt capital markets to raise funds.

y Pakistan s presence in the international capital markets in

2008-09 was limited.

Fiscal Year 2008-09

y Economic activity significantly slowed down in 2008-09. y The current account deficit narrowed to 5.1 per cent of GDP. y Overseas remittances have increased but financial inflows (such as

FDI and portfolio investment) dropped sharply by over 37 per cent due to macroeconomic instability and global recession. months of imports) by end-june 2009 target was 5.2 per cent of GDP.

y SBP foreign exchange reserves rebounded to about $9.1 billion (2.9 y Fiscal problems continued during 2008-09 and the fiscal deficit y Overall revenues fell substantially short of the target primarily due to

a drop in tax revenues as the economic slowdown reduced Pakistan's two main tax bases-manufacturing and imports

Current Scenario Across the Globe:

y The world is trying to recover from the aftermaths of one of the

Greatest Recessions so far with the developing countries like India and China leading the way.

y The World Bank projects global GDP to expand between 2.9 and 3.3

percent in 2010 and 2011, strengthening to between 3.2 and 3.5 percent in 2012, reversing the 2.1 percent decline in 2009.

y Developing economies are expected to grow between 5.7 and 6.2

percent each year from 2010-2012.

y High-income countries, however, are projected to grow by between

2.1 and 2.3 percent in 2010 not enough to undo the 3.3 percent contraction in 2009 followed by between 1.9 and 2.4 percent growth in 2011.

Alternative View
y Taken strong actions to stimulate the economies, provide liquidity, strengthen the capital of financial institutions, protect savings and deposits, unfreeze credit markets, and to ensure that International Financial Institutions (IFIs) can provide critical support for the global economy. y Recognize the importance of monetary policy support, as deemed appropriate to domestic conditions. y Ensure that the IMF, World Bank have sufficient resources to continue playing their role in overcoming the crisis. y Reviewing and aligning global accounting standards, particularly for complex securities in times of stress.

y Governments and Central Banks around the world must be active in supervising and monitoring the activities of financial firms locally and internationally. y International Monetary Fund (IMF) should play a major role in regulating and auditing the global financial system. y Investment companies should be punished for conducting unfair practices in some countries (Tax Evasion) and financial practices must be consistent globally.

y Restrict the leverage that financial institutions can assume. y Establish an early-warning system to help detect systemic risk. y Require stronger capital and liquidity positions for financial firms and related regulatory authority.

Conclusion
y The recession of 2007-09 was considered to be severe, all this showed

us was the need for strong government regulation and oversight of the market in comparison to a completely free market scenario.
y Bailout packages will benefit the firms only in the short run. A firm

will need to assess its financial position and need to take corrective action to prevent such circumstances in the future.
y The question of Global Economic Recovery taking place is highly

debatable however, we can conclude that the recovery is indeed taking place.
y The road to recovery is not smooth and will take a long time before

things get stabilised and everything is back to normal.