Analysis of Worlds Biggest

Financial Crisis
I.
II.
III.
IV.
V.

1929
1987
Asian Financial Crisis
2007 08
LTCM

An assignment on
Analysis of Worlds Biggest
Financial Crisis
Course Title: Financial Engineering

Submitted to:

Course Code: FNB 405

Mr. Nafeez Al Tariq

Course Instructor
Submitted by:
Fahmida Sultana (Student ID: 588)

Tanima Sarker (Student ID: 594)

Bushra Binte Mizan (Student ID: 596)

Salman Rahman (Student ID: 599)
Mehedi Hassan Rana (Student ID: 623)
SM Mahbobul Islam (Student ID: 629)
Kazi Sazzadur Rahman (Student ID: 631)

Department of Finance and Banking

Jahangirnagar University
Savar, Dhaka-1342

25th September, 2014

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World Financial Crisis 1929

Eighty Five years ago, the New York Stock
Exchange experienced the worst financial panic
the country had ever seen. There have been
more crashes since with bigger numbers and
bigger losses but nothing quite rivals the
terror and devastation of Black Tuesday:
October 29, 1929.
When President Calvin Coolidge delivered his
1928 State of the Union address, he noted that
America had never "met with a more pleasing
prospect than that which appears at the
present time." Americans had a lot to be proud
of back then: World War I was thoroughly behind them, radio had been invented, and automobiles were
growing cheaper and more popular. Sure, the disparity between the rich and the poor had widened
within the past decade, but Americans could now buy goods on installment plans a relatively new
concept and families could afford more than ever before. Stocks were on a tear: between 1924 and
1929, the Dow Jones Industrial Average quadrupled. At that time, it was the longest bull market ever
recorded; some thought it would last forever. In the fall of 1929, economist Irving Fisher announced that
"stock prices have reached what looks like a permanent plateau."
As Dow stock average soared throughout the Roaring Twenties, many investors aggressively purchased
shares, comforted by the fact that stocks were thought to be extremely safe by most economists due to
the countrys powerful economic boom. Investors soon purchased stocks on margin, which is the
borrowing of stock for the purpose of gaining financial leverage. For every dollar invested, a margin user
would borrow nine dollars worth of stock. The use of leverage meant that if a stock went up 1%, the
investor would make 10%. Unfortunately, leverage also works the other way around and amplifies even
minor losses. If a stock drops too much, a margin holder could lose all of their investment and possibly
owe money to their broker as well.
From 1921 to 1929, the Dow Jones rocketed from 60 to 400, creating many new millionaires. Very soon,
stock trading became Americas favorite pastime as investors jockeyed to make a quick killing. Investors
mortgaged their homes and foolishly invested their life savings into hot stocks such as Ford and RCA. To
the average investor, stocks were practically a sure thing. Few people actually studied the finances and
underlying businesses of the companies that they invested in. Thousands of fraudulent companies were
formed to hoodwink unsavvy investors. Most investors never even thought a crash was possible in
their minds, the stock market always went up.

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The Timeline for Great Depression:

Event Date:

Event Title:

Oct, 1929

Black Tuesday

Event Description:

The stock market crashes, marking the end of six years of unparalleled
prosperity for most sectors of the American economy. The "crash"
began on October 24 (Black Thursday). By October 29, stock prices had
plummeted and banks were calling in loans. An estimated $30 billion
in stock values "disappeared" by mid-November.
June
17, Smoot-Hawley Congress passes the Smoot-Hawley Tariff, steeply raising import duties
1930
Tariff
in an attempt to protect American manufactures from foreign
competition. The tariff increase has little impact on the American
economy, but plunges Europe farther into crisis.
16th May, Riots
Food riots broke out, workers marched on Detroit, and foreign
1931
workers
were
deported
No major legislation is passed addressing the Depression.
Dec 1931
Major
Bank New York's Bank of the United States collapses in the largest bank
Collapse
failure to date in American history.[M31] $200 million in deposits
disappear, and the bank's customers are left holding the bag.
January
Reconstruction Congress establishes the Reconstruction Finance Corporation. The
1932
R.F.C. is allowed to lend $2 billion to banks, insurance companies,
building and loan associations, agricultural credit organizations and
railroads.
March 1932 Ford Strike
Three thousand unemployed workers march on the Ford Motor
Company's plant in River Rouge, Michigan. Dearborn police and Ford's
company guards attack the workers, killing four and injuring many
more.
April 1932
Unemployed
More than 750,000 New Yorkers are reported to be dependent upon
men line up for city relief, with an additional 160,000 on a waiting list. Expenditures
work
average about $8.20 per month for each person on relief.
November
Roosevelt
Franklin Delano Roosevelt is elected president in a landslide over
1932
Elected
Herbert Hoover. Roosevelt receives 22.8 million popular votes to
Hoover's 15.75 million.
12th Mar, Fireside Chat
President Roosevelt delivers his first radio "fireside chat," explaining to
1933
the American people what has happened in the U.S. banking system.
28th Mar, New President Franklin D. Roosevelt took office. More than 11,000 of the nations
1933
25,000 banks had closed Roosevelt announces a three-day bank
holiday to prevent a third run on banks and to shore up the banking
system. Unemployment reached its highest level, at 25%
April 1933
The
Civilian The first New Deal program, the Civilian Conservation Corps (CCC) is
Conservation
created. Thousands of young men go to camps to work on projects
Corps
such as building parks, building roads, and fighting forest fires.
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May 1933

1934

8th
1935

The Tennessee The Tennessee Valley Authority, another New Deal program, brings
Valley
electricity and jobs to Americans living in the southern part of the
Authority
United States.
Congress authorizes creation of the Federal Communications
Commission, the National Mediation Board and the Securities and
Exchange Commission.
The economy turns around: GNP rises 7.7 percent, and unemployment
falls to 21.7 percent. A long road to recovery begins.
Sweden becomes the first nation to recover fully from the Great
Depression. It has followed a policy of Keynesian deficit spending.

Apr, Emergency
Relief
Appropriation
Act
14th August Social Security
1935
Act

Nov 3, 1936
March 1937

1938

December
7, 1941
December
1941

Congress passes the Emergency Relief Appropriation Act creating the

Works Progress Administration (WPA) and providing almost $5 billion
for work relief for the unemployed for such projects as construction of
airports, schools, hospitals, roads, and public buildings.
the Social Security Act established a system of old-age benefits for
workers, benefits for victims of industrial accidents, unemployment
insurance, aid for dependent mothers and children, the blind, and the
physically handicapped.
FDR
Franklin D. Roosevelt is elected to a second term as president
Another
After showing some improvement, the economy starts to suffer again
Recession
when more Americans lose their jobs. Many people begin to lose hope
that things will ever get better.
No major New Deal legislation is passed after this date, due to
Roosevelt's weakened political power.
the GNP falls 4.5 percent, and unemployment rises to 19.0 percent.
Japan attacks Japan bombs American ships at Pearl Harbor in Hawaii. Thousands of
Pearl Harbor
Americans are killed in the attack.
The
Great The United States declares war on Japan and joins World War II.
Depression
Because the war creates so much money and jobs for the economy,
Ends
the Great Depression ends soon after the U.S. goes to war.

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Timing and severity

The Great Depression began in the United States as an ordinary recession in the summer of 1929. The
downturn became markedly worse, however, in late 1929 and continued until early 1933. Real output
and prices fell precipitously. Between the peak and the trough of the downturn, industrial production in
the United States declined 47 percent and real gross domestic product (GDP) fell 30 percent. The
wholesale price index declined 33 percent (such declines in the price level are referred to as deflation).
Although there is some debate about the reliability of the statistics, it is widely agreed that the
unemployment rate exceeded 20 percent at its highest point. The severity of the Great Depression in
the United States becomes especially clear when it is compared with Americas next worst recession of
the 20th century, that of 198182, when the countrys real GDP declined just 2 percent and the
unemployment rate peaked at less than 10 percent. Moreover, during the 198182 recession prices
continued to rise, although the rate of price increase slowed substantially (a phenomenon known as
disinflation).
The Depression affected virtually every country of the world. However, the dates and magnitude of the
downturn varied substantially across countries. Table 1 shows the dates of the downturn and upturn in
economic activity in a number of countries. Table 2 shows the peak-to-trough percentage decline in
annual industrial production for countries for which such data are available. Great Britain struggled with
low growth and recession during most of the second half of the 1920s. Britain did not slip into severe
depression, however, until early 1930, and its peak-to-trough decline in industrial production was
roughly one-third that of the United States. France also experienced a relatively short downturn in the
early 1930s. The French recovery in 1932 and 1933, however, was short-lived. French industrial
production and prices both fell substantially between 1933 and 1936. Germanys economy slipped into a
downturn early in 1928 and then stabilized before turning down again in the third quarter of 1929. The
decline in German industrial production was roughly equal to that in the United States. A number of
countries in Latin America fell into depression in late 1928 and early 1929, slightly before the U.S.
decline in output. While some less-developed countries experienced severe depressions, others, such as
Argentina and Brazil, experienced comparatively mild downturns. Japan also experienced a mild
depression, which began relatively late and ended relatively early.
Dates of the Great Depression in various countries
(in quarters)
Country
United States

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Depression began Recovery began

1929:3
1933:2

United Kingdom
Germany

1930:1
1928:1

1932:4
1932:3

France
Italy

1930:2
1929:3

1932:3
1933:1

Japan
Canada

1930:1
1929:2

1932:3
1933:2

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Belgium
The Netherlands
Sweden

1929:3
1929:4
1930:2

1932:4
1933:2
1932:3

Switzerland
Denmark

1929:4
1930:4

1933:1
1933:2

Poland
Czechoslovakia

1929:1
1929:4

1933:2
1933:2

Argentina
Brazil

1929:2
1928:3

1932:1
1931:4

India
South Africa

1929:4
1930:1

1931:4
1933:1

Peak-to-trough decline in industrial production in various countries

(annual data)

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Country
United States
United Kingdom
Germany
France
Italy
Japan

Decline
46.8%
16.2%
41.8%
31.3%
33.0%
8.5%

Canada
Belgium

42.4%
30.6%

The Netherlands
Sweden

37.4%
10.3%

Denmark
Poland
Czechoslovakia
Argentina

16.5%
46.6%
40.4%
17.0%

Brazil

7.0%

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The general price deflation evident in the United States was also present in other countries. Virtually
every industrialized country endured declines in wholesale prices of 30 percent or more between 1929
and 1933. Because of the greater flexibility of the Japanese price structure, deflation in Japan was
unusually rapid in 1930 and 1931. This rapid deflation may have helped to keep the decline in Japanese
production relatively mild. The prices of primary commodities traded in world markets declined even
more dramatically during this period. For example, the prices of coffee, cotton, silk, and rubber were
reduced by roughly half just between September 1929 and December 1930. As a result, the terms of
trade declined precipitously for producers of primary commodities.
The U.S. recovery began in the spring of 1933. Output grew rapidly in the mid-1930s: real GDP rose at an
average rate of 9 percent per year between 1933 and 1937. Output had fallen so deeply in the early
years of the 1930s, however, that it remained substantially below its long-run trend path throughout
this period. In 193738 the United States suffered another severe downturn, but after mid-1938 the
American economy grew even more rapidly than in the mid-1930s. The countrys output finally returned
to its long-run trend path in 1942.
Recovery in the rest of the world varied greatly. The British economy stopped declining soon after Great
Britain abandoned the gold standard in September 1931, although genuine recovery did not begin until
the end of 1932. The economies of a number of Latin American countries began to strengthen in late
1931 and early 1932. Germany and Japan both began to recover in the fall of 1932. Canada and many
smaller European countries started to revive at about the same time as the United States, early in 1933.
On the other hand, France, which experienced severe depression later than most countries, did not
firmly enter the recovery phase until 1938.
How the Stock Market Crash of 1929 Happened
In 1929, the Federal Reserve raised interest rates several times in an attempt to cool the overheated
economy and stock market. By October, a powerful bear market had commenced. On Thursday, October
24th 1929, a spate of panic selling occurred as investors began to realize that the stock boom was
actually an over-inflated speculative bubble. Margin investors were being decimated as large numbers
of stock investors tried to liquidate their shares to no avail. Millionaire margin investors went bankrupt
almost instantly when the stock market crashed on October 28th and 29th. During November of 1929,
the Dow sank from 400 to 145. In just three days, over $5 billion worth of market capitalization had
been erased from stocks that were trading on the New York Stock Exchange. By the end of the 1929
stock market crash, a staggering $16 billion worth of market capitalization had been lost from NYSE
stocks.
To make matters worse, many banks had invested their deposits in the stock market, causing these
banks to lose their depositors savings as stocks plunged. Bank runs soon occurred when bank patrons
tried to withdraw their savings from banks all at the same time. Major banks and brokerage firms
became insolvent, adding more fuel to the stock market crash. The financial system was in shambles.
Many bankrupt speculators, some who were once very affluent, committed suicide by jumping out of

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buildings. Even bank patrons who had not invested in shares became broke as $140 billion of depositor
money disappeared and 10,000 banks failed.
What Caused the Great Depression of 1929?
The Great Depression was a global financial crisis that consumed most of the developed world
throughout the 1930s. While the first real indications of its onset can be seen at the end of 1929, most
countries did not feel its true effects until 1930 or later. When it ended also varied from country to
country but signs of recovery were seen in the late 1930s, with things looking up for most economies by
1940.
Importantly, although the Wall Street Crash which took place in October 1929 is often seen as an
interchangeable term for the Great Depression, this event is simply one of the causes emanating from
the US, which led to the longest and deepest worldwide recession of the 20th century. The Great
Depression may have come soon after the collapse of the stock market but this does not mean it
happened because of it; there are many other factors at play that resulted in a more far-reaching
economic crisis.
Farm Depression of the 1920s
One of the critical faults that led to the Great Depression was overproduction. This was not just a
problem in industrial manufacturing, but also an agricultural issue. From as early as the middle of the
1920s, American farmers were producing far more food than the population was consuming. As farmers
expanded their production to aid the war effort during WWI they also mechanized their techniques, a
process which both improved their output but also cost a lot of money, putting farmers into debt.
Furthermore, land prices for many farmers dropped by as much as 40 per cent as a result, the
agricultural system began to fail throughout the 20s, leaving large sections of the population with little
money and no work. Thus, as demand dropped with increasing supply, the price of products fell, in turn
leaving the over-expanded farmers short-changed and farms often foreclosed. This caused
unemployment rise and food production fall by the end of the 1920s.
Overproduction in Industry
While agriculture struggled, industry soared in the decade preceding the Wall Street Crash. In the
boom period before the bust, a lot of people were buying things like cars, household appliances and
consumer products. Importantly, however, these purchases were often made on credit. And as
production continued apace the market quickly dried up; too many products were being produced with
too few people earning enough money to buy them the factory workers themselves, for example,
could not afford the goods coming out of the factories they worked in. The economic crisis that soon
would engulf Europe for reasons to be explained, meant that goods could not be sold across the Atlantic
either, leaving Americas industries to create an unsustainable surplus of products.

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Uneven incomes
In the 1920's American economic policy was laissez faire. Businesses were left alone and for sometime
things appeared to fine. American businesses reported record profits, production was at an all time
high. The problem was that while earnings rose and the rich got richer, the working class received a
disproportionally lower percentage of the wealth. This uneven distribution of wealth got so bad that 5%
of America earned 33% of the income. What this meant was that there was less and less real spending.
Despite the fact that the working class had less money to spend businesses continued to increase
production levels
Low Interest Rate
The run up to the 1929 Equity Market Crash was characterized by easy monetary policy. The FED cut
rates in 1927, and borrowing was cheap until the spring of 1928, when it became only a little more
expensive. Low interest rates made borrowing attractive, so both corporate and financial leverage
increased.
Credit Boom:
In the 1920s, there was a rapid growth in bank credit and loans. Encouraged by the strength of the
economy people felt the stock market was a one way bet. Some consumers borrowed to buy shares.
Firms took out more loans for expansion. Because people became highly indebted, it meant they
became more susceptible to a change in confidence. When that change of confidence came in 1929,
those who had borrowed were particularly exposed and joined the rush to sell shares and try and
redeem their debts.
Buying on the Margin
Related to buying on credit was the practice of buying shares on the margin. This meant you only had to
pay 10 or 20% of the value of the shares; it meant you were borrowing 80-90% of the value of the
shares. This enabled more money to be put into shares, increasing their value. It is said there were many
margin millionaire investors. They had made huge profits by buying on the margin and watching share
prices rise. But, it left investors very exposed when prices fell. These margin millionaires got wiped out
when the stock market fall came. It also affected those banks and investors who had lent money to
those buying on the margin.
Irrational Exuberance
A lot of the Stock Market crash can be blamed on over exuberance and false expectations. In the years
leading up to 1929, the stock market offered the potential for making huge gains in wealth. It was the
new gold rush. People bought shares with the expectations of making more money. As share prices rose,
people started to borrow money to invest in the stock market. The market got caught up in a speculative
bubble. Shares kept rising and people felt they would continue to do so. The problem was that stock
prices became divorced from the real potential earnings of the share prices. Prices were not being
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driven by economic fundamentals but the optimism / exuberance of investors. The average earning per
share rose by 400% between 1923 and 1929. Yet, those who questioned the value of shares were often
labeled doom-mongers.
In March 1929, the stock market saw its first major reverse, but this mini-panic was overcome leading to
a strong rebound in the summer of 1929. By October 1929, shares were grossly overvalued. When some
companies posted disappointing results on October 24 (Black Thursday), some investors started to feel
this would be a good time to cash in on their profits; share prices began to fall and panic selling caused
prices to fall sharply. Financiers, such as JP Morgan tried to restore confidence by buying shares to prop
up prices. But, this failed to alter the rapid change in market sentiment. On October 29(Black Tuesday)
share prices fell by $40 billion in a single day. By 1930 the value of shares had fallen by 90%. The bull
market had been replaced by a bear market.
Weak banking system
A major issue with Americas economic system, above and beyond speculative margin buying, was its
weak banking system. The country had too many small banks, which did not have the resources to cope
with the high demand of people wanting to take their money out when they got nervous about the state
of the stock market. In 1930 a wave of banking closures swept through the mid-eastern states of the US
for this reason. With banks having to sell assets, borrow off other banks or shut down, lending and
credit dried up as this was a large part of fuelling Americas boom period, when it came to an end so
too did the rush of consumer purchasing.
American Economic Policy with Europe
As businesses began failing, the government created the Smoot-Hawley Tariff in 1930 to help protect
American companies. This charged a high tax for imports thereby leading to less trade between America
and foreign countries along with some economic retaliation.
European recession
As America witnessed a turbulent decade of boom and bust in the 1920s and early 30s, Europe too
suffered from its own economic problems.
Most of the economies were left crippled by the effects of WWI, which had seen the workforces
depleted and large amounts of debt incurred, mainly owed to the US. When Americas economy faltered
and it needed money to prevent its ongoing deflation, it called on Britain and France (among other
countries) to repay their debts while also making Germany pay the war reparations.
The fragile economies of Western Europe were not able to survive without the money they had relied
on from the US. As lending from across the Atlantic stopped and President Herbert Hoover requested
the debts to be repaid, these European economies suffered a similar fate as their wartime allies. None of
these countries were able to buy Americas consumer goods, a problem exacerbated by the fact that
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America raised tariffs on imports to an all-time high, which all but ended world trade at a time when
trade and economic stimulus was needed the most.
European economies collapsed when they were already struggling to rebuild themselves unemployment
levels rose, products became overproduced with fewer people able to buy them, the value fell, and
deflation ensued as the economic structure collapsed in on itself. This pattern, first seen in America,
spread to much of the developed world.
Hoovers failures
As has been established, the Great Depression was the result of a multitude of socio-economic factors
over a number of years, not one single event. As such, the finger of blame has often been pointed at
Herbert Hoover, President of the US from 1929-1933; his term as President coincided with the period in
which action needed to be taken to prevent deflation from escalating and government needed to
stabilize a shaky economy. Instead Hoovers policies and actions and he did work hard to try find a
solution to the economic problems are often argued to have worsened the issue around the world,
with not enough being done to prevent the crisis in America getting to the scale it did. Moreover, his
decisions then impacted on other Western countries, which is what brought the depression to a truly
great level.
Although he did try launching initiatives and investing money back into schemes to encourage lending
and unemployment something he often is not credited with enough these tend to be seen as being
too little, too late. His decision to increase tariffs on imports through the Smoot-Hawley tariff stifled
trade with other countries and shrank the size of the market American manufacturers could sell to.
Furthermore, under Hoover the federal government raised its discount rate, making credit even harder
to come by. Other actions he took also came too late plans made in 1932 could not do enough to bail
out banks and put people back in work as the depression had fully taken effect.
Hoovers lack of a proactive approach was exposed by the more substantial action taken by Franklin D
Roosevelt, who succeeded him as President. Initiatives like the New Deal put large numbers back in
work and stopped the downward spiral of unemployment and deflation.
The gold standard
The decision to return to and then stick with the gold standard after WWI by Western nations is often
cited as a key factor in the outbreak of the Great Depression. The gold standard is a system in which
money is fixed against an actual amount of gold. In order for it to work, countries need to maintain high
interest rates to attract international investors who bought foreign assets with gold. When this stops, as
it did at the start of the 1930s, governments often must abandon the gold standard to prevent deflation
from worsening but when this decision had to be made by all countries in order to maintain fixed
exchange rates it wasnt, and the delay in abandoning the gold standard let economic problems worsen
and the size and scale of the Great Depression increase.
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Effects of the Great Depression

The Great Depression was one of the major economic events in world history. It affected every sphere of
life. The outcomes were such that they changed the face of world economy.
1. Economic Effects: As it was a major economic phenomenon it had serious and widespread
economic effects.
Trade Collapse
The Depression became a worldwide business downturn of the 1930s that affected almost all countries.
International commerce declined quickly. There was a sharp reduction in tax revenues, profits and
personal incomes. It affected both countries that exported raw materials and the industrialized
countries. It led to a sharp decrease in world trade as each country tried to protect their own industries
and products by raising tariffs on imports. World Trade collapsed with trade in 1939 still below the 1929
level. It set the wheels rolling towards the end of international gold standards and consequently the
emergence of the fixed exchange rate system.
Reduction in Government Spending
Governments all around the world reduced their spending, which led to decreased consumer demand.
Construction came to a standstill in many nations. As a consequence of government actions, the real
Gross National Product of nations like United States and Britain fell by 30.5%, wholesale prices fell by
30.8%, and consumer prices fell by 24.4%.
Employee Distress
Wages were scaled down to 20 percent, whereas 25 percent of the workforce was left unemployed. This
led to decrease in the standard of living pushing the economy further into the depth of the Depression.
Breakdown of the Financial Machinery
Thousands of investors lost large sums of money and several were wiped out, losing everything. Banks,
stores, and factories were closed and left millions of people jobless, penniless and homeless. In 1929,
659 public sector banks were shut and by the end of 1931 this number rose to 2294. Many people came
to depend on the government or charities to provide them with food.
Effect on Agriculture
Due to lack of subsidies and loans, farmers were unable to support mass produce leading to undercapacity output. Textile farming faced the major blow. The period served as a precursor to one of the
worst droughts in modern American history that struck the Great Plains in 1934. Although a few
segments under agriculture - e.g. cotton - benefited from the crisis, in general the whole agricultural
sector experienced a setback.

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 Political Effects
The Depression had profound political effects. In countries such as Germany and Japan, reaction to the
Depression brought about the rise to power of militarist governments who adopted the aggressive
foreign policies that led to the Second World War. In Germany, weak economic conditions led to the rise
to power of Adolf Hitler. Germany suffered greatly because of the huge debt the country was burdened
by following World War I. The Japanese invaded China and developed mines and industries in
Manchuria. Japan thought that this economic growth would relieve the Depression.
In countries such as the United States and Britain, the government intervened which ultimately resulted
in the creation of welfare systems. Franklin D. Roosevelt became the United States President in 1933. He
promised a "New Deal" under which the government would intervene to reduce unemployment by
work-creation schemes such as painting of the post offices and street cleaning. Both agriculture and
industry were supported by policies to limit output and increase prices.
2. Social and Cultural Effects: This economic catastrophe hit the humans in the worst way
possible. They were surrounded by miseries from all sides. Due to failure of the financial
machinery, masses' faith over the economic system shattered. This resulted in a sudden rise in
the crime rate. Theft, burglary and felony became common occurrences. With no income and
several mouths to feed, workers were pushed to commit suicides. Malnutrition was one of the
severe outcomes of the Depression. Higher education was beyond anyone's reach which
resulted in contraction of the student bodies in all the universities. Due to lack of public
spending, many schools were closed down or understaffed. Professional education was no
longer a priority. One of the key features of this phase was the mass migration. It reshaped the
whole American scenario, people relocated to other countries in search of better employment
opportunities and increased standard of living. Many shifted to California and Arizona to save
themselves from the adversities of the Great Plains. This movement paved the way for various
cultural changes resulting in the diversities we witness today.
A positive outcome of the whole Depression was the emergence of labor unions and the
concept of welfare state. It brought the trend of collective bargaining used during that phase to
voice the concerns of the labor distress, which is a well-defined form of communication in
companies today. In United States, union membership doubled in its size from 1930 to 1940.
Sources of recovery
Given the key roles of monetary contraction and the gold standard in causing the Great Depression, it is
not surprising that currency devaluations and monetary expansion were the leading sources of recovery
throughout the world. There is a notable correlation between the times at which countries abandoned
the gold standard (or devalued their currencies substantially) and when they experienced renewed
growth in their output.

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For example, Britain, which was forced off the gold standard in September 1931, recovered relatively
early, while the United States, which did not effectively devalue its currency until 1933, recovered
substantially later. Similarly, the Latin American countries of Argentina and Brazil, which began to
devalue in 1929, experienced relatively mild downturns and had largely recovered by 1935. In contrast,
the Gold Bloc countries of Belgium and France, which were particularly wedded to the gold standard
and slow to devalue, still had industrial production in 1935 well below that of 1929.
Devaluation, however, did not increase output directly. Rather, it allowed countries to expand their
money supplies without concern about gold movements and exchange rates. Countries that took
greater advantage of this freedom saw greater recovery. The monetary expansion that began in the
United States in early 1933 was particularly dramatic. The American money supply increased nearly 42
percent between 1933 and 1937. This monetary expansion stemmed largely from a substantial gold
inflow to the United States, caused in part by the rising political tensions in Europe that eventually led to
World War II. Monetary expansion stimulated spending by lowering interest rates and making credit
more widely available. It also created expectations of inflation, rather than deflation, thereby giving
potential borrowers greater confidence that their wages and profits would be sufficient to cover their
loan payments if they chose to borrow. One sign that monetary expansion stimulated recovery in the
United States by encouraging borrowing was that consumer and business spending on interest-sensitive
items such as cars, trucks, and machinery rose well before consumer spending on services.
Fiscal policy played a relatively small role in stimulating recovery in the United States. Indeed, the
Revenue Act of 1932 increased American tax rates greatly in an attempt to balance the federal budget,
and by doing so it dealt another contractionary blow to the economy by further discouraging spending.
Franklin D. Roosevelts New Deal, initiated in early 1933, did include a number of new federal programs
aimed at generating recovery. For example, the Works Progress Administration (WPA) hired the
unemployed to work on government building projects, and the Tennessee Valley Authority (TVA)
constructed dams and power plants in a particularly depressed area. However, the actual increases in
government spending and the government budget deficit were small relative to the size of the economy.
This is especially apparent when state government budget deficits are included, because those deficits
actually declined at the same time that the federal deficit rose. As a result, the new spending programs
initiated by the New Deal had little direct expansionary effect on the economy. Whether they may
nevertheless have had positive effects on consumer and business sentiment remains an open question.
Some New Deal programs may have actually hindered recovery. The National Industrial Recovery Act of
1933, for example, set up the National Recovery Administration (NRA), which encouraged firms in each
industry to adopt a code of behavior. These codes discouraged price competition between firms, set
minimum wages in each industry, and sometimes limited production. Likewise, the Agricultural
Adjustment Act of 1933 created the Agricultural Adjustment Administration (AAA), which set voluntary
guidelines and gave incentive payments to farmers to restrict production in hopes of raising agricultural
prices. Modern research suggests that such anticompetitive practices and wage and price guidelines led
to inflation in the early recovery period in the United States and discouraged reemployment and
production.
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Recovery in the United States was stopped short by another distinct recession that began in May 1937
and lasted until June 1938. One source of the 193738 recession was a decision by the Federal Reserve
to greatly increase reserve requirements. This move, which was prompted by fears that the economy
might be developing speculative excess, caused the money supply to cease its rapid growth and to
actually fall again. Fiscal contraction and a decrease in inventory investment due to labor unrest are also
thought to have contributed to the downturn. That the United States experienced a second, very severe
contraction before it had completely recovered from the enormous decline of the early 1930s is the
main reason that the United States remained depressed for virtually the entire decade.
World War II played only a modest role in the recovery of the U.S. economy. Despite the recession of
193738, real GDP in the United States was well above its pre-Depression level by 1939, and by 1941 it
had recovered to within about 10 percent of its long-run trend path. Therefore, in a fundamental sense,
the United States had largely recovered before military spending accelerated noticeably. At the same
time, the U.S. economy was still somewhat below trend at the start of the war, and the unemployment
rate averaged just under 10 percent in 1941. The government budget deficit grew rapidly in 1941 and
1942 because of the military buildup, and the Federal Reserve responded to the threat and later the
reality of war by increasing the money supply greatly over the same period. This expansionary fiscal and
monetary policy, together with widespread conscription beginning in 1942, quickly returned the
economy to its trend path and reduced the unemployment rate to below its pre-Depression level. So,
while the war was not the main impetus for the recovery in the United States, it played a role in
completing the return to full employment.
The role of fiscal expansion, and especially of military expenditure, in generating recovery varied
substantially across countries. Great Britain, like the United States, did not use fiscal expansion to a
noticeable extent early in its recovery. It did, however, increase military spending substantially after
1937. France raised taxes in the mid-1930s in an effort to defend the gold standard but then ran large
budget deficits starting in 1936. The expansionary effect of these deficits, however, was counteracted
somewhat by a legislated reduction in the French workweek from 46 to 40 hoursa change that raised
costs and depressed production. Fiscal policy was used more successfully in Germany and Japan. The
German budget deficit as a percent of domestic product increased little early in the recovery, but it grew
substantially after 1934 as a result of spending on public works and rearmament. In Japan, government
expenditures, particularly military spending, rose from 31 to 38 percent of domestic product between
1932 and 1934, resulting in substantial budget deficits. This fiscal stimulus, combined with substantial
monetary expansion and an undervalued yen, returned the Japanese economy to full employment
relatively quickly

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The Stock Market Crash of 1987

The Stock Market Crash of 1987 or "Black Monday" was the largest one-day market crash in history.
The Dow lost 22.6% of its value or $500 billion dollars on October 19th 1987.
1986 and 1987 were banner years for the stock market. These
years were an extension of an extremely powerful bull market
that had started in the summer of 1982. This bull market had
been fueled by low interest rates, hostile takeovers, leveraged
buyouts and merger mania. Many companies were scrambling
to raise capital to buy each other out. The business philosophy
of the time was that companies could grow exponentially simply
by constantly acquiring other companies. In a leveraged buyout,
a company would raise a massive amount of capital by selling
junk bonds to the public. Junk bonds are bonds that pay high
interest rates due to their high risk of default. The capital raised
through selling junk bonds would go toward the purchase of the
desired company.
IPOs were also becoming a commonplace driver of market excitement. An IPO or Initial Public Offering is
when a company issues stock to the public for the first time. Microcomputers now known as personal
computers were become a fast growing industry. People started to view the personal computer as a
revolutionary tool that would change our way of life, while creating wonderful business opportunities.
The investing public eventually became caught up in a contagious euphoria that was similar to that of
any other historic bubble and market crash. This euphoria made investors, as usual, believe that the
stock market would always go up.
How the Stock Market Crash of 1987 Began:
During this growth boom, the SEC found it increasingly difficult to prevent shady IPOs and
conglomerates from proliferating. In early 1987, the SEC conducted numerous investigations of illegal
insider trading, which created a wary stance among many investors. At the same time, inflation and
overheating became a concern due to the high rate of economic and credit growth. The Federal Reserve
rapidly raised short term interest rates to temper inflation, which dampened some of stock investors
enthusiasm. Many institutional trading firms began to utilize portfolio insurance to protect against
further stock dips. Portfolio insurance is a hedging strategy that uses stock index futures to cushion
equity portfolios against broad stock market declines. As interest rates rose, many institutional money
managers scrambled to hedge their portfolios at the same time. On October 19th 1987, the stock index
futures market was flooded with billions of dollars worth of sell orders within minutes, causing both the
futures and stock markets to crash. In addition, many common stock investors attempted to sell
simultaneously, which completely overwhelmed the stock market.

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On October 19th 1987, $500 billion in market capitalization was evaporated from the Dow Jones stock
index. Markets in nearly every country around the world plunged in a similar fashion. When individual
investors heard that a massive stock market crash was occurring, they rushed to call their brokers to sell
their stocks. This was unsuccessful because each broker had many clients. Many people lost millions of
dollars instantly. There are stories of some unstable individuals who had lost large amounts of money
who went to their brokers office with a gun and started shooting. A few brokers were killed despite the
fact that they had no control over the market action. The majority of investors who were selling did not
even know why they were selling except for the fact that everyone else was selling. This emotionallycharged behavior is one of the main reasons that the stock market crashed so dramatically. After the
October 19th plunge, many futures and stock exchanges were shut down for a day.
Shortly after the crash, the Federal Reserve decided to intervene to prevent an even greater crisis.
Short-term interest rates were instantly lowered to prevent a recession and banking crisis. Remarkably,
the markets recovered fairly quickly from the worst one day stock market crash. Unlike after the stock
market crash of 1929, the stock market quickly embarked on a bull run after the October crash. The
post-crash bull market was driven by companies that bought back their stocks that that the considered
to be undervalued after the market meltdown. Another reason why stocks continued to rise after the
crash was that the Japanese economy and stock market was embarking on its own massive bull market,
which helped to pull the U.S. stock market to previously-unforeseen heights. After the 1987 stock
market crash, as system of circuit breakers were put into place to electronically halt stocks from trading
if they plummet too quickly.
What Caused the Stock Market Crash of 1987?
According to Facts on File, an authoritative source of current-events information for professional
research and education, the 1987 crash marked the end of a five-year 'bull' market that had seen the
Dow rise from 776 points in August 1982 to a high of 2,722.42 points in August 1987." Unlike what
happened in 1929, however, the market rallied immediately after the crash, posting a record one-day
gain of 102.27 the very next day and 186.64 points on Thursday October 22. It took only two years for
the Dow to recover completely; by September of 1989, the market had regained all of the value it had
lost in the '87 crash.
Many feared that the crash would trigger a recession. Instead, the fallout from the crash turned out to
be surprisingly small. This phenomenon was due, in part, to the intervention of the Federal Reserve.
According to Facts on File," The worst economic losses occurred on Wall Street itself, where 15,000 jobs
were lost in the financial industry."
A number of explanations have been offered as to the cause of the crash, although none may be said to
have been the sole determinant. Among these are computer trading and derivative securities, illiquidity,
trade and budget deficits, and overvaluation.

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 Derivative Securities:
Initial blame for the 1987 crash centered on the interplay between stock markets and index options and
futures markets. In the former people buy actual shares of stock; in the latter they are only purchasing
rights to buy or sell stocks at particular prices. Thus options and futures are known as derivatives,
because their value derives from changes in stock prices even though no actual shares are owned. The
Brady Commission [also known as the Presidential Task Force on Market Mechanisms, which was
appointed to investigate the causes of the crash], concluded that the failure of stock markets and
derivatives markets to operate in sync was the major factor behind the crash.
Computer Trading or Program Trading:
In searching for the cause of the crash, many analysts blame the use of computer trading (also known as
program trading) by large institutional investing companies. In program trading, computers were
programmed to automatically order large stock trades when certain market trends prevailed.
There has been some debate about the extent to which program trading, especially portfolio insurance,
contributed to the crash. Portfolio insurance was designed to protect individual investors from losses,
but when used by many investors simultaneously, it may have helped make the fall in prices a systemic
event with a feedback loop.
However, studies show that during the 1987 U.S. Crash, other stock markets which did not use program
trading also crashed, some with losses even more severe than the U.S. market.
Legislation of Tax:
Another cause of the initial break was legislation filed by the House Ways and Means Committee that
would have eliminated tax breaks on debt used for mergers and acquisitions. Tax laws figure very
prominently into valuations of companies, and this caused investors to reconsider the value of their
holdings.
Between Tuesday, October 13, when the legislation was first introduced, and Friday, October 16, when
the market closed for the weekend, stock prices fell more than 10 percent -- the largest 3-day drop in
almost 50 years. In addition, those stocks that led the market downward were precisely those most
affected by the legislation.
U.S. Trade and Budget Deficits :
Bruce Bartlett:
Another important trigger in the market crash was the announcement of a large U.S. trade deficit on
October 14, which led Treasury Secretary James Baker to suggest the need for a fall in the dollar on
foreign exchange markets. Fears of a lower dollar led foreigners to pull out of dollar-denominated
assets, causing a sharp rise in interest rates.
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Website, University of Melbourne:

One belief is that the large trade and budget deficits during the third quarter of 1987 might have led
investors into thinking that these deficits would cause a fall of the U.S. stocks compared with foreign
securities (this was the largest U.S. trade deficit since 1960). However, if the large U.S. budget deficit
was the cause, why did stock markets in other countries crash as well? Presumably if unexpected
changes in the trade deficit were bad news for one country, it would be good news for its trading
partner.
Investing in Bonds as an attractive
Long-term bond yields that had started 1987 at 7.6% climbed to approximately 10% [the summer before
the crash]. This offered a lucrative alternative to stocks for investors looking for yield.
International Financial Markets
We now take it for granted that financial markets are global. Multinational banks dominate the
landscape and investors can buy stocks and bonds across borders with relative ease. But this was not
always the case. It was in the 1980s that stock markets around the world became deeply
interconnected, with American companies increasingly searching for capital abroad and vice versa.
According to Geisst, the 1987 crash spread internationally in a matter of hours, and was quickly a
global phenomenon. Global regulations and standard practices increasingly allowed trading stocks
away from their home exchanges, Geist says
Central Bank Intervention
Alan Greenspan assumed the role of Federal Reserve Chairman in August 1987, just a few months
before the crash. The dollar had been declining for several years due to an international agreement in
1985 to devalue the dollar in order to help American exporters. Fearing that the dollar had fallen too far,
Greenspan took measures to raise interest rates to defend the dollar. According to Geisst, this action
spooked the markets, which had gone through a painful period of high rates in the early 80s.
What are the steps taken against 1987 financial Crisis?
The Federal Reserve Responds to Crises:
In an effort to restrain the declines in financial markets and to prevent any spillovers to the real
economy, the Federal Reserve acted to provide liquidity to the financial system and did so in a public
manner that was aimed at supporting market confidence. One of the most prominent actions of the
Federal Reserve was to issue a statement on Tuesday morning (as noted above) indicating that it would
support market liquidity. This statement was referred to by one market participant as the most calming
thing that was said [Tuesday] (Murray 1987b), and likely contributed to the rebound that morning.

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The Federal Reserve followed-up the statement by carrying out open market operations that pushed the
federal funds rate down to around 7 percent on Tuesday from over 7.5 percent on Monday. This was
done to provide significant liquidity to relieve the turbulence and tension in the wake of the financial
market upheaval.

Other short-term interest rates followed the federal funds rate lower thus reducing costs for borrowers.
For the next several weeks, the Federal Reserve continued to inject reserves to buoy liquidity in financial
markets. Open market operations expanded the Federal Reserve systems securities holdings notably
however, it did not appear to expand exceptionally rapidly.

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The Federal Reserve also worked with banks and securities firms to encourage the availability of credit
to support the liquidity and funding needs of brokers and dealers. The extension of credit by banks to
the securities firms was key to the ability of these firms to meet their clearing and settlement
obligations and to continue to operate in these markets. In testimony given in 1994 to the Senate
Banking Committee, Chairman Greenspan indicated that telephone calls placed by officials of the
Federal Reserve Bank of New York to senior management of the major New York City banks helped to
assure a continuing supply of credit to the clearinghouse members, which enabled those members to
make the necessary margin payments
Government, and in particular U.S. Treasury, securities are often used as collateral in re- purchase
agreements and other financial contracts. Trading and lending these securities is an important source of
market liquidity. After the stock market crash, there was reportedly some reluctance by holders of
government securities to lend them as freely as they typically did, possibly owing to concerns about
counterparty risk, which led to scarcity of some securities and a rise in fails to deliver. Problems trading
government securities could potentially spill over into other markets. To respond to this trend and
enhance liquidity in the government securities market, the Federal Reserve temporarily liberalized the
rules governing lending of securities from its portfolio by suspending the per issue and per dealer limits
on the amount of loans as well as the requirement that the loans not be made to facilitate a short sale.
There were also a variety of supervisory efforts to ensure the soundness of the financial system. The
Federal Reserve placed examiners in major banking institutions and monitored developments. This
action was taken in part to identify potential runs as well as to assess the banking industrys credit
exposure to securities firms through loans, loan commitments, and letters of credit. Monitoring efforts
by the Federal Reserve went beyond the banking industry and included stepped up daily monitoring of
the government securities markets and of the health of primary dealer and inter-dealer brokers. These
latter efforts also involved keeping in close touch with officials from a variety of agencies and
institutions such as the Securities and Exchange Commission, National Association of Securities Dealers,
New York Stock Exchange, and the Treasury Department.
The response of the Federal Reserve, and other regulators, appears to have contributed to improved
market conditions. Reflecting the additions of reserves through open market operations and the
reduction in the federal funds rate, other short-term interest rates declined. The liquidity support likely
contributed substantially toward a return to normal market functioning.18 Within a few days, some
measures of market uncertainty, such as the implied volatility on the S&P 100, declined, although they
remained elevated compared to pre-crash levels.

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The Federal Reserve responses to the stock market crash illustrate three varieties of tools that can be
used when responding to a crisis.
The first variety of tools includes the high-profile public actions taken to support market
sentiment. The most obvious of these is the public statement the morning of Tuesday, Oct. 20
that indicated that the Federal Reserve was taking positive steps to meet market needs for
liquidity.
The second set of tools employed were those that boosted the liquidity of the financial system.
These tools included the use of open market operations and lowering of the federal funds rate
to support the liquidity of the banking system as well as liberalizing the rules regarding lending
of securities from the system account.
Finally, the Federal Reserve encouraged various market participants, in particular banks lending
to brokers and dealers, to work cooperatively and flexibly with their customers. These efforts
appear to have been vital in allowing markets to open Tuesday morning and made an important
contribution to the improvement in market functioning in subsequent weeks.

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Asian Financial Crisis

The Asian Financial Crisis of 1997 was a financial crisis that affected many Asian countries, including
South Korea, Thailand, Malaysia, Indonesia, Singapore and the Philippines. After posting some of the
most impressive growth rates in the world at the time, the so-called "tiger economies" saw their stock
markets and currencies lost about 70% of their value.

The Economic Background:

The Asian crises were, to an extent which is difficult to understand today, unanimously unpredicted.
Debt ratings by international credit rating agencies, spreads on foreign lending, and stock indexes did
not change significantly before the turmoil. Furthermore, both the Asian Development Bank (ADB) and
the International Monetary Fund (IMF) failed to anticipate even any kind of economic and financial
problems.
East Asia (that is, Japan, China, South Korea, Taiwan, and the countries of the Association of Southeast
Asian Nations, ASEAN) had featured, since the 1960s and until the mid-1990s, sustained rapid growth,
with impressive structural change and substantial amelioration in the standard and quality of living of its
population (Asian Development Bank, 1997). The high-performing Asian economies were even praised
by a well-known World Banks report as a miracle (World Bank, 1993). Except Japan and The Philippines,
all East Asian economies were growing at exceptionally high rates during the 1980s and early 1990s. In
1990-1996, East Asia, which accounted for around a fifth of current world gross output, was responsible
for half of international growth and for two-thirds of global investment. Some slowdown appeared in
1996, as shown in the following table, but this was interpreted then by analysts as a minor conjectural
correction. Furthermore, the East Asian developing economies featured during that period a generally
sound developmental path with considerable macro stability.
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Table 1: GDP growth in East Asia, 1980-1997 (%)

Sources: IMF (1998a), tables A2 and A6

High growth and outward orientation

The growth of per capita GNP has been extraordinarily high in East Asia in 1985-1995: 8.4% in Thailand,
8.3% in China; 7.7% in South Korea; 6.2% in Singapore; 6.0% in Indonesia; 5.7% in Malaysia; and 4.8% in
Hong Kong. Only The Philippines (1.5%) lagged behind. Over this period, growth in all low- and middle
income economies was a mere 0.4%, while that of all high-income economies was only 0.8% (World
Bank, 1997: table 1).
According to the ratio of exports to GDP (table 2), all the East Asian economies, with the partial
exception of Indonesia (which had turned somewhat inward), were pursuing export-oriented growth.
Table2. Exports of goods and services/GDP in East Asia, 1980 and 1995

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Generally sound macroeconomic fundamentals

All the main East Asian economies displayed in 1994-1996 low inflation, fiscal surpluses or balances,
limited public debt, high savings and investment rates, and substantial foreign exchange reserves, with
no signs of significant deterioration before the crisis. They also received high and apparently sustainable
capital inflows. According to the Institute of International Finance, net private capital inflows to South
Korea, Indonesia, Malaysia, Thailand and The Philippines rose from US$ 37.9 billion in 1994 to US$ 93.8
billion in 1996. These extremely large capital inflows, mostly by private creditors (which accounted for
US$ 25.8 billion in 1994 and for US$ 76.4 billion in1996), were attracted by: high productivity growth in
the recipient economies, which featured also low labor costs; a hospitable climate there for investment
and commercial activities; relatively high interest rates; and stable nominal exchange rates. These
capital inflows also seemed then sustainable, as it was acknowledged that the bulk was directed towards
investment rather than towards consumption.
The main conclusion, at this point, is that the Asian crises were the result of private and investment
related problems, instead of public and consumption-related difficulties.
However, before the crisis unfolded, some of the East Asian countries had nevertheless several
structural weaknesses. Thailand and Malaysia suffered large current account deficits in a context of
currency appreciation. The ASEAN economies (especially Indonesia and Thailand), and also South Korea,
accumulated substantial foreign debts, mainly private, short-term, denominated in foreign currency, and
largely unhedged. The ASEAN economies (and, to a lesser extent, also Korea) had vigorously pursued the
deregulation of their domestic financial markets and a rapid opening of their capital account (but the
latter was not so intense in Korea). All the main East Asian economies were installed in a process of
overinvestment, as measured by the current account deficits in Thailand and Malaysia and by the high
growth in domestic credit, especially in Malaysia, The Philippines and Thailand.

Table 3: Current account balances in East Asia (as % of GDP), 1995-1997

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The Onset and Development of the Financial Crises

Southeast Asia
Capital inflows to the five main East Asian developing economies increased from US$ 150 billion in 19801989 to as much as US$ 320 billion only in 1990-1995, according to estimates from the IMF (1997a). Pull
factors were low unit labor costs, several incentives to foreign investments and credits, high interest
rates, relatively fixed exchange rates and inadequate financial practices. The latter prompted an
excessive over borrowing from international capital markets, much of it short-term, private,
denominated in foreign currencies, and unhedged. Main push factors were low interest rates in Japan
and, to a lesser extent, also in the US and the EU; excess liquidity in the Western developed economies;
and global financial integration. Except in South Korea, the bulk of those capital inflows was made of
bank loans and foreign direct investment, and not of portfolio flows, prone to be more volatile (Chinn
and Dooley, 1998). In the case of Southeast Asia, these capital inflows had three main adverse
consequences.
First, they exerted an upward pressure on prices in non-tradable goods, which fueled real asset
speculation and created a bubble in the property market (Edison, Luangaram and Miller, 1998).
Second, the excess supply of foreign exchange contributed to a substantial currency
appreciation, which in turn lowered international competitiveness and slowed export growth.
Third, the capital inflows created a large increase in domestic bank lending, raising investment
rates and merchandise imports, and deteriorating the current account.
Moreover, some external shocks aggravated the declining competitiveness. The depreciation of the
Japanese yen respective to the US dollar since mid-1995 and some deterioration in the terms of trade
contributed to the slowdown in export earnings, already apparent in 1996.

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Although indicators of the property bubble are scant, some indirect data suggest that this was the case,
especially in Bangkok and Kuala Lumpur. Between December 1990 and March 1997, real currency
appreciation amounted to 25% in Indonesia and Thailand, 28% in Malaysia, and 47% in The Philippines,
according to estimates from Radelet and Sachs (1998a: table 10). Following data from table B.12 in the
appendix, between the end of 1993 and the end of 1996, domestic currencies featured an appreciation
of 25.5% in Indonesia, 24.0% in the Philippines, 7.8% in Thailand, and 3.2% in Malaysia. The increase in
domestic credit is shown in the following table.

South Korea

Contrary to the case of the Southeast Asian economies, South Korea was not suffering in 1996-1997, at
least to the same degree:
* the increase of domestic bank lending, directed mainly to finance poor quality investments, was
largely absent. The ratio between bank credit to the private sector and GDP increased only modestly
from 57% in 1994-1995 to 62% in 1996 (while it rose, for instance, from 76% to 93% in Malaysia).
Moreover, the bulk of the capital inflow and the domestic capital formation had been used to finance
investment in manufacturing (mainly in export-oriented activities) instead of speculation in real estate
finance;
* the appreciation of the Korean won was much less intense: according to calculations from Radelet and
Sachs (1998a: table 10), between December 1990 and March 1997 the real appreciation of the Korean
won amounted to 11%, much less than the rise registered in Indonesia and Thailand (+25%), Malaysia
(+28%) and The Philippines (+47%). This pattern seems to be validated by data in table B12 in the
appendix;
* Korea did not experience a similar bubble in the property market;

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* Koreas current account deficit amounted to only 2.9% of GDP in 1995-1997, a much lower figure than
Thailands 7.9% or Malaysias 7.4% (both in 1995-1996). Furthermore, the deficit decreased from 4.9% in
1996 to 2.0% in 1997.
Japan
Japan is suffering, since the last quarter of 1997, from a completely distinct crisis, due mainly to
insufficient aggregate domestic demand, although the crises in the rest of East Asia also played a role.
Private consumption, total investment and net exports are all falling, mainly as the result of deflation
fears. Japans worst recession since the World War is deemed to be long-lasting, due to political
disagreements on how to handle financial reform and also to the limits of potential fiscal and monetary
countercyclical policies.
What were the causes?
Financial bubbles and declining returns to investment
According to a first analysis put forward by Krugman (1997), the Asian crises were mainly related to a
burst of a financial bubble in a context of low and declining returns to investment. Market failures in
international capital flows contributed to large inflows in East Asia, while crony capitalism in the
region increased domestic investment in speculation-related real estate, in unsound financial activities,
and in poor quality infrastructures. The short-term breaking or bursting of the ensuing bubble appeared
thus in a framework of low and declining capital returns.
This explanation is severely flawed.
First, the bubble had been building up for a long time, and it could have burst anytime sooner.
Second, Krugmans traditional thesis on low total factor productivity growth (TFPG) has been subjected
to considerable theoretical and empirical challenge.
Third, low and declining returns might certainly explain capital outflows (in 1997-1998) and declining
investment rates (in 1998), but not capital inflows (as in 1990-1996) nor substantial and sustained
investment rates (up to 1996 or 1997), which were common to the East Asian economies before the
crisis.
Bad banking
A second explanation by Krugman (1998a) stressed banking problems as the main element explaining
the crisis. According to his view, deficient regulation of banking activities, some lack of transparency,
and various implicit governmental guarantees (which created moral hazard), led banks and other
financial institutions in Southeast Asia to a situation of over indebtedness and of excessively high levels
of non-performing loans. As a result, overinvestment in fixed capital and land created a financial bubble.
When the bubble burst, banks using assets as collateral for their loans entered a period of crisis,
aggravated further by the collapse in their stock market values. The main problem with this explanation
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is that, after more than a year of protracted crisis, reducing it to a mere banking problem is obviously
too simplistic.
Misguided macro-management
The IMFs analysis of the Asian crises has blamed overheating, fixed exchange rates, financial weakness
(due to excessive regulation and too little competition), some lack of information and transparency, and
loss of confidence (as a result of uncertainties on economic policy).
According to this view (IMF, 1998a and b), fast growth in domestic credit in the East Asian developing
countries created overheated economies. In turn, this resulted in asset inflations, current account
deficits, and large capital inflows. The latter, mainly a consequence of low interest rates in Japan, made
inevitable some significant macroeconomic imbalances, such as currency appreciations and high interest
rates. The rise in real effective exchange rates was also a result of fixed nominal exchange rates with the
US dollar and of the 20% depreciation of the Japanese yen respective to the US dollar between April
1996 and April 1997. As a consequence, there was an adverse swing in competitiveness, which slowed
export growth and raised merchandise imports, and therefore contributed to worsening current
accounts.
Moreover, financial systems in developing East Asia were unsound, due to the traditional practice of
excessive regulation, governmental interference, directed credit, and lending to related parties. Little
competition existed in the banking sector, due to barriers to entry. Banks had accumulated large
amounts of risky assets and they held inadequate capital and reserves ratios.
Some lack of information and transparency was pervasive also in their financial systems, to the extent
that the allegedly powerful regulators and prudential supervisors received incomplete or unreliable
data. In fact, standards for public disclosure fell short of what were necessary, so economic agents were
unable to assess adequately the actual situation of financial institutions.
Political Instability:
Finally, a lack of confidence erupted just before the financial turmoil, mainly as a result of political
uncertainties on the authorities commitment to implement the necessary reforms and adjustments.
This exacerbated the currency depreciations and the decline in stock market indexes and asset prices.
Unsound fundamentals and international capital markets
According to Corsetti, Pesenti and Roubini (1998), the usual suspects indicating a potential currency
crisis (slowing growth, high budget deficits, high inflation, and substantial current account deficits over
several years) were not observed in East Asia in 1990-1996. However, unsound fundamentals were, in
their view, at the heart of the turmoil. Following their analysis, Southeast Asia and Korea were suffering,
especially since 1995, from a combination of several imprudent macroeconomic policies:

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(i) a fixed exchange peg to the US dollar, which led to substantial real currency appreciations;
(ii) an investment boom, which created a savings-investment gap, leading to large and growing current
account deficits;
(iii) an excessive lending to risky and low-profitability projects, due to political pressures to the moral
hazard that domestic financial institutions were facing, and to the mix of exchange pegs and relatively
low internal interest rates;
(iv) very weak and fragile financial systems, as a result of the existence of implicit or explicit
governmental guarantees to lenders and of the lack of prudential regulation and supervision, in a
context of domestic and external financial liberalization; and
(v) the accumulation of foreign debt in the form of short-term, foreign-currency denominated and
unhedged liabilities.
In this context, the rational behavior of international financial markets led to speculative attacks on the
East Asian currencies, which created a vicious circle of competitive devaluations, and to a sharp reversal
in 1997 of the capital flows in the region, to which international investors lent excessively until 1996.
Self-fulfilling panics in external financial markets
This is the explanation of Radelet and Sachs (1998a and b) and Sachs (1998). They list three main causes
of the crisis:
- the intrinsic instability of international financial markets, subjected to bouts of panic and clearly
overactive: international loan markets are prone to self-fulfilling crisis in which individual creditors may
act rationally and yet market outcomes produce sharp, costly and fundamentally unnecessary panicked
reversals in capital flows (Radelet and Sachs, 1998b: 4).
- several external macroeconomic shocks in East Asia, including the surge of new competitors (China and
Mexico) and the depreciation of the yen vis--vis the US dollar;
- weaknesses in the East Asian financial systems, which had their roots in attempts at financial
deregulation and opening.
As a result, when capital flows waned in late 1996 and early 1997, a financial panic erupted following a
series of missteps by the Asian governments, market participants, the IMF, and the international
community. The result was a much deeper crisis than was necessary or inevitable (Radelet and Sachs,
1998b: 12).
Financial deregulations and speculative attacks
Wade and Veneroso (1998a and b) and Wade (1998a, b, and c) point to two main factors explaining the
crises:

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(i) the removal in the early 1990s of the traditional institutional structure of government-banks-firms
collaboration and of restrictions in the capital account; and
(ii) an overreaction of international financial markets, which led to a panicky pullout from economies
with no underlying real vulnerabilities.
The pre-existing financial structure of the East Asian economies was centered on relatively high levels of
intermediation from savers to banks and relatively high levels of corporate debt to equity. This
conferred developmental advantages but also made for financial fragility. Once restrictions on capital
flows were removed and the triangular collaboration came to be steered, financial fragility was more
exposed:
Recovery:
The impact of the financial crisis went beyond the economic landscape. While Thailand and South Korea
went through peaceful changes in their governments, other countries experienced political upheavals
after the economic dislocation.
However, as painful as it was, the crisis has also given affected countries the incentives and political
momentum needed to make their economic systems more open and transparent. Over the past decade,
these countries have attempted to repair the structural defects that led to the crisis. Unlike previous
economic crises in Mexico and Latin America, the Asian crisis was not caused by excessive government
spending or unmanageable public debt, but instead was mainly rooted in the private sector.
To their credit, most
Asian
governments
have taken steps to
address their problems
by reforming financial
sectors,
improving
transparency of regulations, strengthening
corporate governance,
and opening their
markets
to
more
competition.
In
addition, they have
continued to promote
their
economic
advantages by embracing foreign trade and seizing opportunities to integrate themselves into the global
trading system. (See Chart 1) Their overall total trade with the world has increased despite some
slowdowns.

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Although it took time for post-crisis reforms to restore investor confidence, the subsequent recovery
was stronger and swifter than has been typical in other emerging-market financial crises.Ten years after
the financial crisis, the Asian countries are rebounding. Real GDP per capita in the affected countries has
passed its pre-crisis level. Production fell sharply in 1997 and 1998, but positive growth resumed almost
immediately. Most countries had bounced back to the same point by 2003 and are now even more
"miraculous" than before.

A Critical View of the IMF Remedies

The IMF programs: the case of South Korea
The IMF mistook the East Asian crisis as a traditional balance-of-payments problem, while in fact the
turmoil reflected mainly a debt deflation process. As Kregel (1998a and b) pointed out, debt deflations
(studied in the 1960s by H. Minsky, following I. Fisher in the 1930s) arise when companies, in order to
repay their foreign currency debts, try to sell their assets, inventories or current outputs. This lowers the
price of their potential sales while, at the same time, raising the demand for foreign exchange. High
interest rates, in this context, may increase foreign currency demand more than its supply, contrary to
conventional IMFs expectations. In order to assess the IMFs approach in dealing with the East Asian
crises, some reflections on the case of South Korea are listed below.
In November 1997, the Korean government asked the IMF for financial help. The Fund organized a
rescue package of US$ 57 billion, the largest in its history. The breakdown of this amount was as follows:

US$ 22 billion from the main trade partners of Korea;

US$ 21 billion directly from the IMF;
US$ 10 billion from the World Bank; and
US$ 4 billion from the Asian Development Bank (ADB).

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The IMFs stand-by credit of SDR 15.5 billion (US$ 21 billion), which amounted to more than 20 times the
Korean quota to the Fund, involved an austerity program and several structural reforms, with four main
areas:
1. MACROECONOMIC POLICIES: In order to eliminate the current account deficit and to contain inflation
to single digits in 1998, the government had to pursue stringent fiscal and monetary policies. Two main
measures were attached to the IMF credit:
(1) a package of tax increases and expenditure cuts, intended to render a small surplus in the budget
balance in 1998 (from -0.5% of GDP in 1997), and to slow import demand; the IMF had initially
demanded a fiscal surplus of as much as 1% of GDP but subsequently dropped this request;
(2) a substantial increase in interest rates, in order to defend the currency, along with more
governmental control on the expansion of the monetary supply, directed at controlling inflation.
2. FINANCIAL SECTOR RESTRUCTURING: Strengthening prudential regulation by monetary authorities,
revocation of licenses of several merchant banks, and rationalization of the commercial financial
institutions;
3. CAPITAL ACCOUNT AND TRADE LIBERALIZATION: Acceleration of financial opening, with full
liberalization of the money market instruments, allowance of foreign investment in domestic financial
institutions, authorization for foreign banks and brokerage houses to establish subsidiaries and
elimination of ceilings on foreign investment in Korean equities; trade opening, which involved
abolishing trade-related subsidies and liberalizing merchandise imports and foreign financial services.
4. LABOR MARKET REFORM: The labor market will have to be flexibilized, clarifying the circumstances
and procedures for layoffs. Under the World Bankss US$ 10 billion Structural Adjustment Loan, the
details of these measures have been discussed, in accordance with the Tripartite Accord reached
between the government, the unions and the business community on February 6, 1998. The restrictive
macroeconomic policies resulted in a drop in domestic demand, as consumer demand decreased, due to
adverse income and wealth effects, and as investment contracted sharply, as a result of very high
interest rates. Together with the currency depreciation, this would certainly allow for a substantial
amelioration in the trade and current account balances. It should be noticed that this amelioration,
although positive in itself, has a also a negative side: e.g. more trade frictions with the Western trading
partners of Korea, many of which have sizeable bilateral trade deficits.
Conclusions:
The analysis of the East Asian financial crises is a challenge but necessary task. The Asian turmoil, which
erupted in 1997, represents a new kind of crises, different in many aspects to those depicted in the firstgeneration and second-generation literature on currency crises in developing countries. This might
explain why the Asian episodes were largely unpredicted. It also calls for a third-generation theoretical
model of currency crises and for a new set of indicators or predictors.

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The Asian crises highlight the importance of sound macroeconomic policies and, especially, the need to
avoid large current account balances in a context of substantial real currency appreciation. One of the
main lessons of the Asian crises has been that imprudent and improperly sequenced financial
liberalization in emerging economies increases their vulnerability to speculative attacks. Domestic
financial deregulation should be attempted only after creating an adequate supervisory and prudential
regulatory framework. Moreover, financial opening should follow, and not precede, the strengthening of
the domestic financial sector. More precisely, regulating and taxing short-term and potentially volatile
international capital flows seem to be necessary steps in order to avoid disruptive processes in an
otherwise sound macroeconomic environment.
Turning now to the international implications of the Asian crises, the role of the IMF as a manager of the
turmoil has been widely criticized. It seems that the IMF is unable to deal with financial crises in the
present era of financial globalization. Therefore, a reassessment of its functions and programs in
developing economies is surely needed. Moreover, several international measures to encourage more
stable capital flows to emerging markets (such as regulating and supervising short-term bank loans and
portfolio investments) should be explored in order to reduce international financial fragility.

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World Financial Crisis 2007 - 08

Before the Beginning
Like all previous cycles of booms and busts, the seeds of the subprime meltdown were sown during
unusual times. In 2001, the U.S. economy experienced a mild, short-lived recession. Although the
economy nicely withstood terrorist attacks, the bust of the dotcom bubble, and accounting scandals, the
fear of recession really preoccupied everybody's minds.
To keep recession away, the Federal Reserve lowered the Federal funds rate 11 times - from 6.5% in
May 2000 to 1.75% in December 2001 - creating a flood of liquidity in the economy. Cheap money, once
out of the bottle, always looks to be taken for a ride. It found easy prey in restless bankers - and even
more restless borrowers who had no income, no job and no assets. These subprime borrowers wanted
to realize their life's dream of acquiring a home. For them, holding the hands of a willing banker was a
new ray of hope. More home loans, more home buyers, more appreciation in home prices. It wasn't
long before things started to move just as the cheap money wanted them to.
This environment of easy credit and the upward spiral of home prices made investments in higher
yielding subprime mortgages look like a new rush for gold. The Fed continued slashing interest rates,
emboldened, perhaps, by continued low inflation despite lower interest rates. In June 2003, the Fed
lowered interest rates to 1%, the lowest rate in 45 years. The whole financial market started resembling
a candy shop where everything was selling at a huge discount and without any down payment. "Lick
your candy now and pay for it later" - the entire subprime mortgage market seemed to encourage those
with a sweet tooth for have-it-now investments. Unfortunately, no one was there to warn about the
tummy aches that would follow.
But the bankers thought that it just wasn't enough to lend the candies lying on their shelves. They
decided to repackage candy loans into collateralized debt obligations (CDOs) and pass on the debt to
another candy shop. Soon a big secondary market for originating and distributing subprime loans
developed. To make things merrier, in October 2004, the Securities Exchange Commission (SEC) relaxed
the net capital requirement for five investment banks - Goldman Sachs, Merrill Lynch, Lehman Brothers,
Bear Stearns and Morgan Stanley - which freed them to leverage up to 30-times or even 40-times their
initial investment. Everybody was on a sugar high, feeling as if the cavities were never going to come.
The Beginning of the End
But, every good item has a bad side, and several of these factors started to emerge alongside one
another. The trouble started when the interest rates started rising and home ownership reached a
saturation point. From June 30, 2004, onward, the Fed started raising rates so much that by June 2006,
the Federal funds rate had reached 5.25% (which remained unchanged until August 2007).
Declines Begin
There were early signs of distress: by 2004, U.S. homeownership had peaked at 70%; no one was
interested in buying or eating more candy. Then, during the last quarter of 2005, home prices started to
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fall, which led to a 40% decline in the U.S. Home Construction Index during 2006. Not only were new
homes being affected, but many subprime borrowers now could not withstand the higher interest rates
and they started defaulting on their loans.
This caused 2007 to start with bad news from multiple sources. Every month, one subprime lender or
another was filing for bankruptcy. During February and March 2007, more than 25 subprime lenders
filed for bankruptcy, which was enough to start the tide. In April, well-known New Century Financial also
filed for bankruptcy.
Investments and the Public
Problems in the subprime market began hitting the news, raising more people's curiosity. Horror stories
started to leak out.
According to 2007 news reports, financial firms and hedge funds owned more than $1 trillion in
securities backed by these now-failing subprime mortgages - enough to start a global financial tsunami if
more subprime borrowers started defaulting. By June, Bear Stearns stopped redemptions in two of its
hedge funds and Merrill Lynch seized $800 million in assets from two Bear Stearns hedge funds. But
even this large move was only a small affair in comparison to what was to happen in the months ahead.
August 2007: The Landslide Begins
It became apparent in August 2007 that the financial market could not solve the subprime crisis on its
own and the problems spread beyond the United States borders. The interbank market froze
completely, largely due to prevailing fear of the unknown amidst banks. Northern Rock, a British bank,
had to approach the Bank of England for emergency funding due to a liquidity problem. By that time,
central banks and governments around the world had started coming together to prevent further
financial catastrophe.
Multidimensional Problems
The subprime crisis's unique issues called for both conventional and unconventional methods, which
were employed by governments worldwide. In a unanimous move, central banks of several countries
resorted to coordinated action to provide liquidity support to financial institutions. The idea was to put
the interbank market back on its feet.
The Fed started slashing the discount rate as well as the funds rate, but bad news continued to pour in
from all sides. Lehman Brothers filed for bankruptcy, IndyMac bank collapsed, Bear Stearns was
acquired by JP Morgan Chase, Merrill Lynch was sold to Bank of America, and Fannie Mae and Freddie
Mac were put under the control of the U.S. federal government.
By October 2008, the Federal funds rate and the discount rate were reduced to 1% and 1.75%,
respectively. Central banks in England, China, Canada, Sweden, Switzerland and the European Central
Bank (ECB) also resorted to rate cuts to aid the world economy. But rate cuts and liquidity support in
itself were not enough to stop such a widespread financial meltdown.
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The U.S. government then came out with National Economic Stabilization Act of 2008, which created a
corpus of $700 billion to purchase distressed assets, especially mortgage-backed securities. Different
governments came out with their own versions of bailout packages, government guarantees and
outright nationalization.
Subprime mortgage crisis
The subprime mortgage crisis is an ongoing financial crisis triggered by a significant decline in housing
prices and related mortgage payment delinquencies and foreclosures in the United States. This caused a
ripple effect across the financial markets and global banking systems, as investments related to housing
prices declined significantly in value, placing the health of key financial institutions and governmentsponsored enterprises at risk. Funds available for personal and business spending (i.e., liquidity) declined
as financial institutions tightened lending practices. The crisis, which has roots in the closing years of the
20th century but has become more apparent throughout 2007 and 2008, has passed through various
stages exposing pervasive weaknesses in the global financial system and regulatory framework.
The crisis began with the bursting of the United States housing bubble and high default rates on
subprime and adjustable rate mortgages (ARM), beginning in approximately 20052006. Government
policies and competitive pressures for several years prior to the crisis encouraged higher risk lending
practices. Further, an increase in loan incentives such as easy initial terms and a long-term trend of rising
housing prices had encouraged borrowers to assume difficult mortgages in the belief they would be able
to quickly refinance at more favorable terms. However, once interest rates began to rise and housing
prices started to drop moderately in 20062007 in many parts of the U.S., refinancing became more
difficult. Defaults and foreclosure activity increased dramatically as easy initial terms expired, home
prices failed to go up as anticipated, and ARM interest rates reset higher. Foreclosures accelerated in
the United States in late 2006 and triggered a global financial crisis through 2007 and 2008. During 2007,
nearly 1.3 million U.S. housing properties were subject to foreclosure activity, up 79% from 2006.
Financial products called mortgage-backed securities (MBS), which derive their value from mortgage
payments and housing prices, had enabled financial institutions and investors around the world to invest
in the U.S. housing market. Major Banks and financial institutions had borrowed and invested heavily in
MBS and reported losses of approximately US$435 billion as of 17 July 2008. The liquidity and solvency
concerns regarding key financial institutions drove central banks to take action to provide funds to
banks to encourage lending to worthy borrowers and to restore faith in the commercial paper markets,
which are integral to funding business operations. Governments also bailed out key financial
institutions, assuming significant additional financial commitments.
The risks to the broader economy created by the housing market downturn and subsequent financial
market crisis were primary factors in several decisions by central banks around the world to cut interest
rates and governments to implement economic stimulus packages. These actions were designed to
stimulate economic growth and inspire confidence in the financial markets. Effects on global stock
markets due to the crisis have been dramatic. Between 1 January and 11 October 2008, owners of stocks
in U.S. corporations had suffered about $8 trillion in losses, as their holdings declined in value from $20
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trillion to $12 trillion. Losses in other countries have averaged about 40%. Losses in the stock markets
and housing value declines place further downward pressure on consumer spending, a key economic
engine. Leaders of the larger developed and emerging nations met in November 2008 to formulate
strategies for addressing the crisis.
The credit crunch
As people defaulted on their mortgages, the value of their assets (houses) declined, and the institutions
that held those assets were threatened with insolvency (Foley, 2009: 13). When two Bear Stearns hedge
funds collapsed in July 2007 a severe credit crunch developed (Foster and Magdoff, 2009: 98).
Institutions were unwilling to lend freely to each other because they were unsure of the levels of toxic
assets they were holding. It was the start of the global financial crisis and the flow of credit to the real
economy threatened to dry up (Foley, 2009: 14).
During the pre-financial crisis of 2008, a lot of the population were already suffering from the subprime
mortgage crisis. Reckless borrowing by consumers along with excessive leveraging of Wallstreet
brought the US to the brink. Everybody was caught by surprise when the news broke out and the
degree on how Wallstreet really messed up was the focus of everybodys attention.
Understanding credit risk:
Credit risk arises because a borrower has the option of defaulting on the loan he owes. Traditionally,
lenders (who were primarily thrifts) bore the credit risk on the mortgages they issued. Over the past 60
years, a variety of financial innovations have gradually made it possible for lenders to sell the right to
receive the payments on the mortgages they issue, through a process called securitization. The resulting
securities are called mortgage backed securities (MBS) and collateralized debt obligations (CDO). Most
American mortgages are now held by mortgage pools, the generic term for MBS and CDOs. Of the $10.6
trillion of USA residential mortgages outstanding as of midyear 2008, $6.6 trillion were held by mortgage
pools and $3.4 trillion by traditional depository institutions.
This originate to distribute model means that investors holding MBS and CDOs also bear several types
of risks, and this has a variety of consequences. There are four primary types of risk: credit risk on the
underlying mortgages, asset price risk, liquidity risk, and counterparty risk. When homeowners default,
the payments received by MBS and CDO investors decline and the perceived credit risk rises. This has
had a significant adverse effect on investors and the entire mortgage industry. The effect is magnified by
the high debt levels (financial leverage) households and businesses have incurred in recent years.
Finally, the risks associated with American mortgage lending have global impacts, because a major
consequence of MBS and CDOs is a closer integration of the USA housing and mortgage markets with
global financial markets.
Investors in MBS and CDOs can insure against credit risk by buying Credit defaults swaps (CDS). As
mortgage defaults rose, the likelihood that the issuers of CDS would have to pay their counterparties
increased. This created uncertainty across the system, as investors wondered if CDS issuers would honor
their commitments.
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Causes of Financial crisis:

The reasons for this crisis are varied and complex. The crisis can be attributed to a number of factors
pervasive in both the housing and credit markets, which developed over an extended period of time.
There are many different views on the causes, including the inability of homeowners to make their
mortgage payments, poor judgment by the borrower and/or the lender, speculation and overbuilding
during the boom period, risky mortgage products, high personal and corporate debt levels, complex
financial innovations that distributed and perhaps concealed default risks, central bank policies, and
government regulation (or alternatively lack thereof). In its 15 November 2008 Declaration of the
Summit on Financial Markets and the World Economy, leaders of the Group of 20 cited the following
causes:
During a period of strong global growth, growing capital flows, and prolonged stability earlier this
decade, market participants sought higher yields without an adequate appreciation of the risks and
failed to exercise proper due diligence. At the same time, weak underwriting standards, unsound risk
management practices, increasingly complex and opaque financial products, and consequent excessive
leverage combined to create vulnerabilities in the system. Policy-makers, regulators and supervisors, in
some advanced countries, did not adequately appreciate and address the risks building up in financial
markets, keep pace with financial innovation, or take into account the systemic ramifications of
domestic regulatory actions.
In its 15 November 2008 Declaration of the Summit on Financial Markets and the World Economy,
leaders of the Group of 20 cited the following causes:
Boom and bust in the housing market
United States housing bubble and United States housing market correction. Existing homes sales,
inventory, and months supply, by quarter. Common indexes used for adjustable rate mortgages (1996
2006). Low interest rates and large inflows of foreign funds created easy credit conditions for many
years leading up to the crisis.[Subprime lending and borrowing was a major contributor to an increase in
home ownership rates and the demand for housing. The U.S. home ownership rate increased from 64%
in 1994 (about where it was since 1980) to a peak in 2004 with an all-time high of 69.2%.
This demand helped fuel housing price increases and consumer spending. Between 1997 and 2006,
American home prices increased by 124%. For the two decades until 2001, the national median home
price went up and down, but it remained between 2.9 and 3.1 times the median household income. By
2004, however, the ratio of home prices to income hit 4.0, and by 2006 the ratio was 4.6. [ Some
homeowners used the increased property value experienced in the housing bubble to refinance their
homes with lower interest rates and take out second mortgages against the added value to use the
funds for consumer spending. U.S. household debt as a percentage of income rose to 130% during 2007,
versus 100% earlier in the decade. A culture of consumerism is a factor in an economy based on
immediate gratification. Americans spent $800 billion per year more than they earned. Household debt
grew from $680 billion in 1974 to $14 trillion in 2008, with the total doubling since 2001. During 2008,

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the average U.S. household owned 13 credit cards, and 40 percent of them carried a balance, up from 6
percent in 1970.
Overbuilding during the boom period eventually led to a surplus inventory of homes, causing home
prices to decline, beginning in the summer of 2006. Easy credit, combined with the assumption that
housing prices would continue to appreciate, had encouraged many subprime borrowers to obtain
adjustable-rate mortgages they could not afford after the initial incentive period. Once housing prices
started depreciating moderately in many parts of the U.S., refinancing became more difficult. Some
homeowners were unable to re-finance and began to default on loans as their loans reset to higher
interest rates and payment amounts.
An estimated 8.8 million homeowners, nearly 10.8% of total homeowners, had zero or negative equity
as of March 2008, meaning their homes are worth less than their mortgage. This provided an incentive
to walk away from the home, despite the credit rating impact. In the U.S., home mortgages are nonrecourse loans, meaning the creditor cannot seize other property or income to cover a default. The U.S.
is virtually unique in such arrangements. By November 2008, 12 million homeowners had negative
equity. As more homeowners stop paying their mortgages, foreclosures and the supply of homes
increase. This places downward pressure on housing prices, which places more homeowners upside
down, continuing the cycle. The declining mortgage payments also reduce the value of mortgage-backed
securities, eating away at the financial health of banks. This vicious cycle is at the heart of the crisis.
Increasing foreclosure rates increased the supply of housing inventory available. Sales volume (units) of
new homes dropped by 26.4% in 2007 versus the prior year. By January 2008, the inventory of unsold
new homes stood at 9.8 months based on December 2007 sales volume, the highest level since 1981.
Further, a record of nearly four million unsold existing homes were for sale,[ including nearly 2.9 million
that were vacant.
This excess supply of home inventory placed significant downward pressure on prices. As prices
declined, more homeowners were at risk of default and foreclosure. According to the S&P/Case-Shiller
price index, by November 2007, average U.S. housing prices had fallen approximately 8% from their Q2
2006 peak and by May 2008 they had fallen 18.4%. The price decline in December 2007 versus the yearago period was 10.4% and for May 2008 it was 15.8%.Housing prices are expected to continue declining
until this inventory of surplus homes (excess supply) is reduced to more typical levels.
Speculation
Speculation in real estate was a contributing factor. During 2006, 22% of homes purchased (1.65 million
units) were for investment purposes, with an additional 14% (1.07 million units) purchased as vacation
homes. During 2005, these figures were 28% and 12%, respectively. In other words, nearly 40% of home
purchases (record levels) were not primary residences. NARs chief economist at the time, David Lereah,
stated that the fall in investment buying was expected in 2006. Speculators left the market in 2006,
which caused investment sales to fall much faster than the primary market.

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While homes had not traditionally been treated as investments like stocks, this behavior changed during
the housing boom. For example, one company estimated that as many as 85% of condominium
properties purchased in Miami were for investment purposes. Media widely reported the behavior of
purchasing condominiums prior to completion, then flipping (selling) them for a profit without ever
living in the home. Some mortgage companies identified risks inherent in this activity as early as 2005,
after identifying investors assuming highly leveraged positions in multiple properties.
Keynesian economist Hyman Minsky described three types of speculative borrowing that can contribute
to the accumulation of debt that eventually leads to a collapse of asset values: the hedge borrower
who borrows with the intent of making debt payments from cash flows from other investments; the
speculative borrower who borrows based on the belief that they can service interest on the loan but
who must continually roll over the principal into new investments; and the Ponzi borrower (named for
Charles Ponzi), who relies on the appreciation of the value of their assets (e.g. real estate) to refinance
or pay-off their debt but cannot repay the original loan. The role of speculative borrowing has been
cited as a contributing factor to the subprime mortgage crisis.
High-risk mortgage loans and lending practices:
A variety of factors have caused lenders to offer an increasing array of higher-risk loans to higher-risk
borrowers, including illegal immigrants. The share of subprime mortgages to total originations was 5%
($35 billion) in 1994, 9% in 1996, 13% ($160 billion) in 1999, and 20% ($600 billion) in 2006.A study by
the Federal Reserve indicated that the average difference in mortgage interest rates between subprime
and prime mortgages (the subprime markup or risk premium) declined from 2.8 percentage points
(280 basis points) in 2001, to 1.3 percentage points in 2007. In other words, the risk premium required
by lenders to offer a subprime loan declined. This occurred even though subprime borrower credit
ratings and loan characteristics declined overall during the 20012006 period, which should have had
the opposite effect. The combination is common to classic boom and bust credit cycles.
In addition to considering higher-risk borrowers, lenders have offered increasingly high-risk loan options
and incentives. These high risk loans included the No Income, No Job and no Assets loans, sometimes
referred to as Ninja loans. In 2005 the median down payment for first-time home buyers was 2%, with
43% of those buyers making no down payment whatsoever.
Another example is the interest-only adjustable-rate mortgage (ARM), which allows the homeowner to
pay just the interest (not principal) during an initial period. Still another is a payment option loan, in
which the homeowner can pay a variable amount, but any interest not paid is added to the principal.
Further, an estimated one-third of ARM originated between 2004 and 2006 had teaser rates below
4%, which then increased significantly after some initial period, as much as doubling the monthly
payment.
Mortgage underwriting practices have also been criticized, including automated loan approvals that
critics argued were not subjected to appropriate review and documentation. In 2007, 40% of all
subprime loans were generated by automated underwriting. The chairman of the Mortgage Bankers

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Association claimed mortgage brokers profited from a home loan boom but did not do enough to
examine whether borrowers could repay. Mortgage fraud has also increased.
Securitization practices
Securitization is structured finance process in which assets, receivables or financial instruments are
acquired, pooled together as collateral for the third party investments (Investment banks). There are
many parties involved. Due to the securitization, investor appetite for mortgage-backed securities
(MBS), and the tendency of rating agencies to assign investment-grade ratings to MBS, loans with a high
risk of default could be originated, packaged and the risk readily transferred to others. Asset
securitization began with the structured financing of mortgage pools in the 1970s. In 1995 the
Community Reinvestment Act (CRA) was revised to allow for the securitization of CRA loans into the
secondary market for mortgages.
The traditional mortgage model involved a bank originating a loan to the borrower/homeowner and
retaining credit (default) risk. With the advent of securitization, the traditional model has given way to
the originate to distribute model, in which the credit risk is transferred (distributed) to investors
through MBS. The securitized share of subprime mortgages (i.e., those passed to third-party investors
via MBS) increased from 54% in 2001, to 75% in 2006. Securitization accelerated in the mid-1990s. The
total amount of mortgage-backed securities issued almost tripled between 1996 and 2007, to $7.3
trillion. The debt associated with the origination of such securities was sometimes placed by major
banks into off-balance sheet entities called structured investment vehicles or special purpose entities.
Moving the debt off the books enabled large financial institutions to circumvent capital reserve
requirements, thereby assuming additional risk and increasing profits during the boom period. Such offbalance sheet financing is sometimes referred to as the shadow banking system and is thinly regulated.
Alan stated that the securitization of home loans for people with poor credit not the loans
themselves were to blame for the current global credit crisis.
However, instead of distributing mortgage-backed securities to investors, many financial institutions
retained significant amounts. The credit risk remained concentrated within the banks instead of fully
distributed to investors outside the banking sector. Some argue this was not a flaw in the securitization
concept itself, but in its implementation.
Some believe that mortgage standards became lax because of a moral hazard, where each link in the
mortgage chain collected profits while believing it was passing on risk. Under the CRA guidelines, a bank
gets credit originating loans or buying on a whole loan basis, but not holding the loans. So, this gave the
banks the incentive to originate loans and securitize them, passing the risk on others. Since the banks no
longer carried the loan risk, they had every incentive to lower their underwriting standards to increase
loan volume. The mortgage securitization freed up cash for banks and thrifts, this allowed them to make
even more loans. In 1997, Bear Sterns bundled the first CRA loans into MBS.

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Inaccurate credit ratings

Credit rating agencies are now under scrutiny for giving investment-grade ratings to securitization
transactions (CDOs and MBSs) based on subprime mortgage loans. Higher ratings were believed justified
by various credit enhancements including over-collateralization (pledging collateral in excess of debt
issued), credit default insurance, and equity investors willing to bear the first losses. However, there are
also indications that some involved in rating subprime-related securities knew at the time that the rating
process was faulty. Internal rating agency emails from before the time the credit markets deteriorated,
released publicly by U.S. congressional investigators, suggest that some rating agency employees
suspected at the time that lax standards for rating structured credit products would produce widespread
negative results. For example, one 2006 email between colleagues at Standard & Poors states Rating
agencies continue to create and [sic] even bigger monsterthe CDO market. Lets hope we are all
wealthy and retired by the time this house of cards falters.
High ratings encouraged the flow of investor funds into these securities, helping finance the housing
boom. The reliance on ratings by these agencies and the intertwined nature of how ratings justified
investment led many investors to treat securitized products some based on subprime mortgages
as equivalent to higher quality securities and furthered by SEC removal of regulatory barriers and
reduced disclosure requirements in the wake of the scandal. Critics claim that conflicts of interest were
involved, as rating agencies are paid by the firms that organize and sell the debt to investors, such as
investment banks. On 11 June 2008 the U.S. Securities and Exchange Commission proposed far-reaching
rules designed to address perceived conflicts of interest between rating agencies and issuers of
structured securities.
Rating agencies lowered the credit ratings on $1.9 trillion in mortgage backed securities from Q3 2007 to
Q2 2008. This places additional pressure on financial institutions to lower the value of their MBS. In turn,
this may require these institutions to acquire additional capital, to maintain capital ratios. If this involves
the sale of new shares of stock, the value of existing shares is reduced. In other words, ratings
downgrades pressured MBS and stock prices lower.
Collapse of the Stock Markets
The collapse of the stock market together with the fall of several financial institutions were events
reminiscent to the pre-great depression of the late 1920s and a lot of people thought that another great
depression is on the horizon. As the 2008 financial crisis was still building its momentum, easy money
fueled the housing sector like a well-oiled machine that also occured in the 1920s. Ever since the US
government lowered the mortgage rate to 1 percent, people of every status could virtually own a
house. Because of this, mortgages and other types of loans were easily granted by nearly all banks
across the country without even doing some important checks on them. The tendency to lie about how
much money one makes was very widespread at the time and anyone who can present a credit rating
passes. Loans were even granted to people who dont have jobs simply because this crucial information
are not verified by lenders.

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Though risky, plenty of lenders dont mind giving way these loans because of a financing tool identified
as mortgage-backed securities. These loans were bulked and resold to banks in Wallstreet and banks in
Wallstreet bundle these loans into higher yielding mortgage-backed securities and sold to investors
around the globe. These newly converted loans then became pooled risks as many investors across
the planet now have their share on them and because of this aspect it was thought that it will always be
protected
Government policies
Both government action and inaction have contributed to the crisis. Several critics have commented that
the current regulatory framework is outdated. President George W. Bush stated in September 2008:
Once this crisis is resolved, there will be time to update our financial regulatory structures. Our 21st
century global economy remains regulated largely by outdated 20th century laws. The Securities and
Exchange Commission (SEC) has conceded that self-regulation of investment banks contributed to the
crisis. Increasing home ownership was a goal of both Clinton and Bush administrations. [80][81][82] There is
evidence that the government influenced participants in the mortgage industry, including Fannie Mae
and Freddie Mac (the GSE), to lower lending standards. [83][84][85] The U.S. Department of Housing and
Urban Developments mortgage policies fueled the trend towards issuing risky loans.
In 1995, the GSE began receiving government incentive payments for purchasing mortgage backed
securities which included loans to low income borrowers. This resulted in the agencies purchasing
subprime securities. Subprime mortgage loan originations surged by 25% per year between 1994 and
2003, resulting in a nearly ten-fold increase in the volume of these loans in just nine years. These
securities were very attractive to Wall Street, and while Fannie and Freddie targeted the lowest-risk
loans, they still fueled the subprime market as a result. In 1996 the Housing and Urban Development
(HUD) agency directed the GSE to provide at least 42% of their mortgage financing to borrowers with
income below the median in their area. This target was increased to 50% in 2000 and 52% in 2005. By
2008, the GSE owned or guaranteed nearly $5 trillion in mortgages and mortgage-backed securities,
close to half the outstanding balance of U.S. mortgages. The GSE were highly leveraged, having
borrowed large sums to purchase mortgages. When concerns arose regarding the ability of the GSE to
make good on their guarantee obligations in September 2008, the U.S. government was forced to place
the companies into a conservatorship, effectively nationalizing them at the taxpayers expense.
Liberal economist Robert Kuttner has criticized the repeal of the Glass-Steagall Act by the Gramm-LeachBliley Act of 1999 as possibly contributing to the subprime meltdown, although other economists
disagree. A taxpayer-funded government bailout related to mortgages during the savings and loan crisis
may have created a moral hazard and acted as encouragement to lenders to make similar higher risk
loans.
Additionally, there is debate among economists regarding the effect of the Community Reinvestment
Act, with detractors claiming it encourages lending to less creditworthy consumers and defenders
claiming a thirty year history of lending without increased risk. Detractors also claim that amendments
to the CRA in the mid-1990s, raised the amount of home loans to otherwise unqualified low-income
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borrowers and also allowed for the first time the securitization of CRA-regulated loans containing
subprime mortgages.
Policies of central banks
Central banks are primarily concerned with managing monetary policy; they are less concerned with
avoiding asset bubbles, such as the housing bubble and dot-com bubble. Central banks have generally
chosen to react after such bubbles burst to minimize collateral impact on the economy, rather than
trying to avoid the bubble itself. This is because identifying an asset bubble and determining the proper
monetary policy to properly deflate it are a matter of debate among economists.
Federal Reserve actions raised concerns among some market observers that it could create a moral
hazard. Some industry officials said that Federal Reserve Bank of New York involvement in the rescue of
Long-Term Capital Management in 1998 would encourage large financial institutions to assume more
risk, in the belief that the Federal Reserve would intervene on their behalf.
A contributing factor to the rise in home prices was the lowering of interest rates earlier in the decade
by the Federal Reserve, to diminish the blow of the collapse of the dot-com bubble and combat the risk
of deflation. From 2000 to 2003, the Federal Reserve lowered the federal funds rate target from 6.5% to
1.0%. The central bank believed that interest rates could be lowered safely primarily because the rate of
inflation was low and disregarded other important factors. The Federal Reserves inflation figures,
however, were flawed. Richard W. Fisher, President and CEO of the Federal Reserve Bank of Dallas,
stated that the Federal Reserves interest rate policy during this time period was misguided by this
erroneously low inflation data, thus contributing to the housing bubble.
Financial institution debt levels and incentives
Many financial institutions borrowed enormous sums of money during 20042007 and made
investments in mortgage-backed securities (MBS), essentially betting on the continued appreciation of
home values and sustained mortgage payments. Borrowing at a lower interest rate to invest at a higher
interest rate is using financial leverage. This is analogous to an individual taking out a second mortgage
on their home to invest in the stock market. This strategy magnified profits during the housing boom
period, but drove large losses after the bust. Financial institutions and individual investors holding MBS
also suffered significant losses as a result of widespread and increasing mortgage payment defaults or
MBS devaluation beginning in 2007 onward.
A SEC regulatory ruling in 2004 greatly contributed to US investment banks ability to take on additional
debt, which was then used to purchase MBS. The top five US investment banks each significantly
increased their financial leverage during the 20042007 time period (see diagram), which increased
their vulnerability to the MBS losses. These five institutions reported over $4.1 trillion in debt for fiscal
year 2007, a figure roughly 30% the size of the U.S. economy. Three of the five either went bankrupt
(Lehman Brothers) or were sold at fire-sale prices to other banks (Bear Stearns and Merrill Lynch) during
September 2008, creating instability in the global financial system. The remaining two converted to
commercial bank models, subjecting themselves to much tighter regulation.
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In 2006, Wall Street executives took home bonuses totaling $23.9 billion, according to the New York
State Comptrollers Office. Wall Street traders were thinking of the bonus at the end of the year, not
the long-term health of their firm. The whole systemfrom mortgage brokers to Wall Street risk
managersseemed tilted toward taking short-term risks while ignoring long-term obligations. The most
damning evidence is that most of the people at the top of the banks didnt really understand how those
[investments] worked.
Credit default swaps
Credit defaults swaps (CDS) are insurance contracts, typically used to protect bondholders or MBS
investors from the risk of default. As the financial health of banks and other institutions deteriorated
due to losses related to mortgages, the likelihood that those providing the insurance would have to pay
their counterparties increased. This created uncertainty across the system, as investors wondered which
companies would be forced to pay to cover defaults.
CDS may be used to insure a particular financial exposure or may be used speculatively. Trading of CDS
increased 100-fold from 1998 to 2008, with debt covered by CDS contracts ranging from U.S. $33 to $47
trillion as of November 2008 CDS are lightly regulated. During 2008, there was no central clearinghouse
to honor CDS in the event a key player in the industry was unable to perform its obligations. Required
corporate disclosure of CDS-related obligations has been criticized as inadequate. Insurance companies
such as AIG, MBIA, and Ambac faced ratings downgrades due to their potential exposure due to
widespread debt defaults. These institutions were forced to obtain additional funds (capital) to offset
this exposure. In the case of AIG, its nearly $440 billion of CDS linked to MBS resulted in a U.S.
government bailout.
In theory, because credit default swaps are two-party contracts, there is no net loss of wealth. For every
company that takes a loss, there will be a corresponding gain elsewhere. The question is which
companies will be on the hook to make payments and take losses, and will they have the funds to cover
such losses. When investment bank Lehman Brothers went bankrupt in September 2008, it created a
great deal of uncertainty regarding which financial institutions would be required to pay off CDS
contracts on its $600 billion in outstanding debts. Significant losses at investment bank Merrill Lynch
were also attributed in part to CDS and especially the drop in value of its unhedged mortgage portfolio
in the form of Collateralized Debt Obligations after American International Group ceased offering CDS
on Merrils CDOs. Trading partners loss of confidence in Merril Lynchs solvency and ability to refinance
short-term debt ultimately led to its sale to Bank of America.
Policy Initiatives for Remedies
To tackle the imminent impact of the global crisis, policy preparedness and timely action are required as
suggested by the experts. The Government of Bangladesh announced on April 19, 2009 an interim
package of fiscal and policy supports for the countrys agriculture, power and export sectors to help
combat the immediate effects of the ongoing global recession (Table 2). To finance the package an
additional allocation of Tk 34.24 billion will be needed in the revised budget for the current fiscal year.
Under the fiscal support part of the package for the April-June period of the FY 2008-09, the rates of
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export subsidy have been increased for three sectors which are jute, leather, and frozen food. With the
raise, the rate of cash subsidy on jute and jute goods has gone up to 10 per cent from the existing 7.5
per cent while the same has increased to 17.5 per cent from 15 percent for leather and leather goods
and 12.5 per cent from 10 percent for frozen foods (Figure 6). Cash support rates for other export items
remain unchanged. Because of the increase in export subsidy to three sectors the government would
require to allocate an additional amount of Tk 4.50 billion. Consequently, the total amount of export
subsidy would rise to Tk 15 billion in the revised budget for the FY 2008-09 as opposed to the existing
allocation of Tk 10.50 billion.
The government has also made an attempt to help the local shrimp operators boost their productivity
by achieving quality standard set by the European Union. Attempts will be taken by the government to
identify the causes behind the failure of the local pharmaceutical and ceramic industries for not being
able to achieve their respective export targets. On the remittance front, the government plans to
strengthen its diplomatic
efforts in the countries,
especially where large
numbers of Bangladeshi
people are employed, to
help protect their jobs
and also explore new
markets for employment.
The Tk 34.24 billion
stimulus package, which
has focuses on domestic
fronts by prioritizing
power and agriculture
sector, is expected to
bring positive result in
the long run. There are
signs that the government is trying to ward off the negative impact of the global recession on the export
sector by paying attention to issues such as increasing competitiveness and reducing cost of production.
For instance the cost of production will go down allowing export sector to increase its competitiveness
eventually, if power production goes up.
The initiatives taken by the government also suggests that to weaken the effects of global recession, the
government is reviewing public spending and strengthening social safety nets to help come through the
storm of the global crisis. In a continued effort, the government is likely to set forth a big budget of Tk.
113000 crore for the next fiscal year to allocate more money for social safety nets, subsidies,
development programs, and additional salaries for government staff. It would possibly be 13 percent
bigger than the current fiscal years original budget of Tk. 99,962 crore, and about 18 percent larger than
the probable revised budget. Economists, however have enough doubts about how much implemental
the new budget will be, considering the implementation efficiency and quality.
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Conclusion
In summary, while the crisis is not over yet, we certainly hope the worst is behind us. Corrective action is
still needed and the lessons we are learning are ongoing. That said, we have learned, in fact re-learned,
that while crises may manifest themselves in different ways, with new instruments, in new markets, and
sometimes in newly created types of institutional frameworks, one of the items that remains the same is
that incentives are often at the root of a crisis. Often altering incentives is a difficult job as market
participants and the official sector have gotten comfortable in their various roles, rules, and regulations.
But it is time to re-evaluate how incentives altered the buildup to the latest crisis and its aftermath and
how they can be redirected to reinforce self-corrective forces in financial markets rather than
destructive ones. The Fund can play a role in putting forth possible options, joining with various
international organizations and standard setters to discuss them, and acting as a focal point for such
discussions, and can help disseminate the new best practices or rule-making throughout its membership
to foster a more secure global economic and financial environment.
The global financial crisis, brewing for a while, really started to show its effects in the middle of 2008.
Around the world stock markets have fallen, large financial institutions have collapsed or been bought
out, and governments in even the wealthiest nations have had to come up with rescue packages to bail
out their financial systems.
On the one hand many people are concerned that those responsible for the financial problems are the
ones being bailed out, while on the other hand, a global financial meltdown will affect the livelihoods of
almost everyone in an increasingly inter-connected world. The problem could have been avoided, if
ideologues supporting the current economics models werent so vocal, influential and inconsiderate of
others viewpoints and concerns.

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The Story of Long Term Capital Management (LTCM)

What really happened to cause the failure of the hedge fund
The 1998 failure of Long-Term Capital Management (LTCM) is said to have nearly blown up the world's
financial system.1 indeed, the fund's woes threatened to create major losses for its Wall Street lenders.
LTCM was so big that the Federal Reserve Bank of New York took the unprecedented step of facilitating
a bailout of the private hedge fund, out of fear that a forced liquidation might ravage world markets.

This issue is vitally important, as LTCM's failure has been widely ascribed to its use of Value at Risk (VaR),
the disturbing implication that the method currently used to set capital adequacy requirements for the
banking sector is woefully inadequate. VaR itself was not the culprit, however. Rather it was the way this
risk management tool was employed. LTCM used parameters for the model suitable for a commercial
bank, but entirely unsuitable for a hedge fund. As an example, one of the parameters used to set the
amount of equity capital was a 10-day horizon. The horizon must be related to the liquidity of the assets,
or the time necessary for an orderly liquidation. Alternatively, the horizon should cover the time
necessary to raise additional funds or for corrective action. Ten days may be sufficient for a commercial
bank, which is closely supervised by a regulator who can step in at the first sign of trouble. For a hedge
fund, however, the horizon should correspond to the period required to raise additional funds. This may
be no easy matter, as additional capital will be needed precisely after the fund suffers a large loss. The
10-day horizon was clearly insufficient for LTCM. This, and the other unsuitable parameters produced a
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flawed model, which led LTCM to drastically underestimate the amount of capital they should set aside
against market risks. At the same time, many other factors conspired to bring LTCM down as well.
How LTCM Lost its Capital
The seeds of LTCM can be traced to a highly profitable bond-arbitrage group at Salomon Brothers run by
John Meriwether. LTCM was founded in 1994 by Meriwether, who left after the 1991 Salomon bond
scandal. Meriwether took with him a group of traders and academics, who had been part of Salomon's
bond-arbitrage group that had racked up billions of dollars in profits. Together, they set up a "hedge"
fund using similar principles to those they had been using at Salomon.
A hedge fund is a private investment partnership fund that can take long and short positions in various
markets and is accessible only to large investors. As such, hedge funds are not regulated by the SEC. Of
course, the term "hedge" is somewhat of a misnomer, if not misleading, since these investment vehicles
are leveraged and can be quite risky.
Initially, the new venture was eminently profitable. Capital grew from $1 billion to more than $7 billion
by 1997. The firm was charging sky-high fees consisting of an annual charge of 2% of capital plus 25% of
profits. By comparison, other hedge funds charge a 1% fixed fee and 20% of profits; the typical mutual
fund fee is about 1.41%. By 1997, total fees had grown to about $1.5 billion. LTCM's 16 partners had
invested roughly $1.9 billion of their own money in the fund.
Much has been said about LTCM's positions in the press. LTCM was supposed to have wagered $125
billion. This represents the total assets of the fund, most of it borrowed.2 Compared to equity of about
$5 billion only, the size of assets appears ludicrous.
Even more scary was the off balance sheet position, including swaps, options, repurchase agreements
and other derivatives, that added up to a notional principal amount of over $1 trillion. Many of these
trades, however, were offsetting each other, so that this notional amount is practically meaningless.
What mattered was the total risk of the fund.
LTCM was able to leverage its balance sheet through sale-repurchase agreements (repos) with
commercial and investment banks. Under "repo" agreements, the fund sold some of its assets in
exchange for cash and a promise to repurchase them back at a fixed price on some future date.
Normally, brokers require collateral that is worth slightly more than the cash loaned, by an amount
known as a haircut, designed to provide a buffer against decreases in the collateral value. In the case of
LTCM, however, the fund was able to obtain next-to-zero haircuts, as it was widely viewed as "safe" by
its lenders. This must have been due to the fact that no counterparty had a complete picture of the
extent of LTCM's operations.
The core strategy of LTCM can be described as "convergence-arbitrage" trades, trying to take advantage
of small differences in prices among near-identical bonds. Compare, for instance, a corporate bond
yielding 10% and an otherwise identical Treasury bond with a yield of 7%. The yield spread of 3%
represents some compensation for credit risk. If the corporate borrower does not default, a trade that is
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long the corporate bond and short the Treasury bond would be expected to return 3% for every dollar in
the first bond. Short-term, the position will be even more profitable if the yield spread narrows further.
The key is that eventually the two bonds must converge to the same value. Most of the time, this will
happen - barring default or market disruption.
This strategy worked excellently for LTCM in 1995 and 1996, with after-fees returns above 40%. The
fund placed large bets on convergence of European interest rates within the European Monetary System
that paid off handsomely.
By 1997, however, convergence had occurred in Europe, as the common currency, the Euro, came into
being on January 1999. Credit spreads were almost as narrow as they had ever been since 1986 and
considerably lower than the average over the period 1986-93. Convergence trades had generally
become less profitable. In 1997, the fund's return was down to only 17%. This performance,
unfortunately, was trounced by U.S. stocks, which gained 33%. This was embarrassing, as LTCM touted
itself as having the same risk as equities. If it had lower returns, why would anybody invest in the fund?
LTCM had to look for other opportunities.
To achieve the 40% returns it had become accustomed to, the firm had to assume greater leverage. So,
LTCM returned $2.7 billion of capital to investors in 1997 while keeping total assets at $125 billion. By
shrinking the capital base to $4.7 billion, the leverage ratio went up, amplifying returns to investors that
remained in the fund. Unfortunately, this also increased the risks. Troubles began in May and June of
1998. A downturn in the mortgage-backed securities market led to a 16% loss in the value of equity.
LTCM's capital had just dropped from $4.7 to $4.0 billion.
Then came August 17. Russia announced that it was "restructuring" its bond payments - de facto
defaulting on its debt. This bombshell led to a reassessment of credit and sovereign risks across all
financial markets. Credit spreads jumped up sharply. Stock markets dived. LTCM lost $550 million on
August 21 alone on its two main bets, long interest rate swap spreads and short stock market volatility.
By August, the fund had lost 52% of its December 31 value. Its equity had dropped faster than its assets,
which still stood around $110 billion. The resulting leverage ratio had increased from 27 to 50-to-1.
LTCM badly needed new capital. In his September 2 letter to investors, Meriwether revealed the extent
of the losses and wrote that "Since it is prudent to raise additional capital, the Fund is offering you the
opportunity to invest on special terms related to LTCM fees.
The portfolio's losses accelerated. On September 21, the fund lost another $500 million, mostly due to
increased volatility in equity markets. Bear Stearns, LTCM's prime broker, faced a large margin call from
a losing LTCM T-bond futures position. It then required increased collateral, which depleted the fund's
liquid resources. Counterparties feared that LTCM could not meet further margin calls, in which case
they would have to liquidate their repo collateral.
A liquidation of the fund would have forced dealers to sell off tens of billions of dollars of securities and
to cover their numerous derivatives trades with LTCM. Because lenders had required very low haircuts,
there was a potential for losses to accrue while the collateral was being liquidated. In addition, as the
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fund was organized in the Cayman Islands, there was uncertainty as to whether the lenders could have
liquidated their collateral. In contrast, such liquidation is explicitly allowed under the U.S. Bankruptcy
Code. As it was believed that the fund could have sought bankruptcy protection under Cayman law,
LTCM's lenders could have been exposed to major losses on their collateral.
The potential effects on financial markets were such that the New York Federal Reserve felt compelled
to act. On September 23, it organized a bailout of LTCM, encouraging 14 banks to invest $3.6 billion in
return for a 90% stake in the firm.
These fresh funds came just in time to avoid meltdown. By September 28, the fund's value had dropped
to only $400 million. If August was bad, September was even worse, with a loss of 83%. Investors had
lost a whopping 92% of their year-to-date investment. Of the $4.4 billion lost, $1.9 billion belonged to
the partners, $700 million to Union Bank of Switzerland, and $1.8 billion to other investors.
LTCM is now operating under the control of a 14-member consortium, formally known as Oversight
Partners I LLC. Helped by recovering financial markets, the portfolio gained 13% to December 1998.
Since the bailout, the risk profile has been halved.

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