US Economic Crisis EXECUTIVE SUMMARY

Economic crisis occurs as the result of the heavy cost of war, unemployment and low prices and low levels of trade and investment. In September and October 2008, the US suffered a severe economic crisis. This was the worst crisis since the Great Depression.. This was the result of large scale defaults in the US housing market as the banks went on providing risky loans without adequate security and the repaying capacity of the borrower. The principal source of transmission of the crisis has been the real sector, generally referred to as the Main Street. This crisis engulfed the United States in the form of creeping recession and this worsened the situation. As a consequence, US demand for imports from other countries indicated a decline. It is difficult to pin down the exact cause of the financial crisis, but majority of the experts and economists are of the view that subprime loans in the housing sector was one of the most important cause of the economic crisis of 2008. Other causes include U.S. greedy investment bankers; foolish investors; imprudent bankers; incompetent rating agencies; irresponsible housing speculators; short sighted homeowners; and predatory mortgage brokers, lenders, and borrowers--all played a part, but they were only following the economic incentives that government policy laid out for them. The crisis has produced or exacerbated serious, wide-ranging yet differentiated impacts across the globe. The major impacts are Deceleration of growth, economic contraction; Negative effects on trade balances and balance of payments, Dwindling levels of foreign direct investment, wide spread unemployment, reduced international trade and Contract action of world trade etc.

To overcome the problems the US government as well as The U.S. Federal Reserve has taken up a variety of regulatory measures such as consumer protection, executive pay, bank financial cushions or capital requirements, expanded regulation of the shadow banking system and derivatives, and enhanced authority for the Federal Reserve. But it will take time to recover from this situation.

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Contents
1. What is Economic crisis? ............................................................................................................ 3
1.1. Symptoms of Economic crisis.................................................................................................. 3

2. 3. 4.

The global Economic Crisis of 2008........................................................................................... 3 US Economic Crisis ....................................................................................................................... 4 Causes of US Economic Crisis ..................................................................................................... 4
4.1. 4.2. 4.3. 4.4. 4.5. 4.6. 4.7. 4.8. 4.9. Boom and bust in the housing market.................................................................................... 4 Collapse of stock prices ........................................................................................................... 6 Speculation.............................................................................................................................. 6 Government Policies ............................................................................................................... 7 Central Bank policies ............................................................................................................... 7 Collapse of major investment banks in 2008 .......................................................................... 7 Short-Term Interest Rates....................................................................................................... 8 Iraq and Afghanistan War ....................................................................................................... 8 Higher Leverage Ratios ........................................................................................................... 9

4.10. Limited Amount of Oil in America........................................................................................... 9

5. 6.

Impact of US Crisis ..................................................................................................................... 10 Steps Taken by US Government to Overcome the Crisis .................................................... 11
6.1. 6.2. 6.3. 6.4. 6.5. 6.6. 6.7. Systemic risk regulator .......................................................................................................... 11 Bank capital requirements & leverage restrictions .............................................................. 11 Short-selling restriction......................................................................................................... 11 Mortgage lending regulations ............................................................................................... 12 Financial Products Safety Commission (FPSC) ...................................................................... 12 Increasing Authority of U.S. Federal Reserve ....................................................................... 12 Establishment of Trade Facilitation Facility (TFF) ................................................................. 12

7.

Was the Crisis Avoidable? ........................................................................................................ 12

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1. What is Economic crisis?
Economic crisis is a situation in which the economy of a country experiences a sudden downturn brought on by a financial crisis. An economy facing an economic crisis will most likely experience a falling GDP, a drying up of liquidity and rising/falling prices due to inflation/deflation. In other words economic crisis means periods of low, or even negative, economic growth. This means that production levels are lower and entails increased unemployment. As a result, the bargaining position of workers is weakened and their wages decline. Economic crisis occurs as the result of the heavy cost of war, unemployment and low prices and low levels of trade and investment.

1.1.

Symptoms of Economic crisis

There are three common symptoms of economic crises: a balance of payments crisis, government spending exceeding government revenues, and rapid inflation. A balance of payments situation arises, most simply, when the earnings from exports are insufficient to meet the costs of imports. In the short term, this imbalance of trade may be prolonged, without provoking an economic crisis, if other funding sources can be found. Thus, money borrowed by the government, foreign investment, or foreign aid payments, might bridge the gap between export earnings and import costs, but these courses become unsustainable over long periods of time.

2. The global Economic Crisis of 2008

The global Economic Crisis of 2008 is the most severe economic crisis that the world has ever faced since the Great Depression of the 1930s. The economic Crisis of 2008 , also called the US Meltdown, has its origin in the United States housing sector back in 2001-02, but gradually extended over a period of time and eventually brought the entire world under its grip. The economic crisis is characterized by contracted liquidity in the global

credit and housing market, triggered by the failure of mortgage companies, investment banks, and government institutions which had heavily invested in

subprime loans. Though the crisis started in 2005-06, but has become more visible during 2007-08, when many of the renowned Wall Street firms collapsed.

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3. US Economic Crisis
With the collapse of Lehman Brothers and other Wall Street icons, there was growing recession which affected the US, the European Union (EU) and Japan. This was the result of large scale defaults in the US housing market as the banks went on providing risky loans without adequate security and the repaying capacity of the borrower. The principal source of transmission of the crisis has been the real sector, generally referred to as the Main Street. This crisis engulfed the United States in the form of creeping recession and this worsened the situation. As a consequence, US demand for imports from other countries indicated a decline. The basic cause of the crisis was largely an unregulated environment, mortgage lending to subprime borrowers. Since the borrowers did not have adequate repaying capacity and also because subprime borrowing had to pay two-to-three percentage points higher rate of interest and they have a history of default, the situation became worse. But once the housing market collapsed, the lender institutions saw their balance-sheets go into red. A redeeming feature of the current crisis is that its magnitude was much lesser than that of the Great Depression of the 1930s when unemployment rate in the United States exceeded 25per cent. But in this crisis it stood at 6.5 per cent and was predicted to remain around eight per cent in 2009.

4. Causes of US Economic Crisis

It is difficult to pin down the exact cause of the financial crisis, but majority of the experts and economists are of the view that subprime loans in the housing sector was one of the most important cause of the economic crisis of 2008.

The different causes of the crisis are specified below:

4.1.

Boom and bustin the housing market

The crisis actually started with the bursting of housing bubble that began in 2001 and started growing at a rapid rate until it reached its peak in 2005. The housing bubble occurred due to rapid increase in the rate of the valuation of real property until the prices of the property reached the unsustainable level. The factors that led to the rapid increase in the demand for house price are-- low interest rate and the huge inflow of foreign capital from countries such as China, Japan U.K. , U.S.

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consumers lured by the increasing value of their homes went on borrowing spree. They started borrowing money for consumption by mortgaging their property. Figure 1 Annual Existing House Price Change

Source: www.standardpoors.com, S and P Case-Schiller Housing Price Index. Housing prices were relatively stable during the 1990s, but they began to rise toward the end of the decade. Between January 2002 and mid-year 2006, housing prices increased by a whopping 87 percent. The boom had turned to a bust, and the housing price declines continued throughout 2007 and 2008. By the third quarter of 2008, housing prices were approximately 25 percent below their 2006 peak. But overbuilding during the boom period and rise in interest rate led to the bursting of the bubble. Between 2004 and 2006 the Federal Reserve Board raised the interest rate by 17 times, up from 1 percent to 5.25 percent. Also, overbuilding during the boom eventually led to a surplus inventory of houses, causing home prices to decline, beginning in summer, 2006. (Bianco, 2008)

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4.2. Collapse of stock prices
The UN stock prices are shown in the following figure Figure 2 Stock Market Returns
60% 50% 40% 30% 20% 10% 0% -10% -20% -30% -40%
19 50 19 53 19 56 19 59 19 62 19 65 19 68 19 71 19 74 19 77 19 80 19 83 19 86 19 89 19 92 19 95 19 98 20 01 20 04 20 07

Source: www.standardpoors.com As of mid-December of 2008, stock returns were down by 37 percent since the beginning of the year. This is nearly twice the magnitude of any year since 1950. This collapse eroded the wealth and endangered the retirement savings of many Americans.

4.3.
observed

Speculation
that investment investment in housing sector yield high return compared avenues. As a result investment to

Another important cause of housing crisis is speculation in real estate. It was

other traditional

in housing

sector increased. During 2006, 22 per cent of homes purchased (1.65 million units) were for investment purposes, with an additional 14 per cent (1.07 million

units) purchased as vacation homes. Nearly 40 per cent of home purchases were not for primary residences. A hoping 85 percent of the houses purchased in Miami were for investment purposes.(Wikipedia)

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4.4. Government Policies
To provide house at affordable price to all the people was the priority of both the Clinton and Bush administration. In 1974, President Carter passed the Community Reinvestment Act. This Act made mandatory for all the banks and saving institution to provide home loans to the lower income people in broad outlying areas where they had branch. The U.S. Department of Housing and Urban Developments Mortgage policies fueled the trend towards issuing risky loans.

4.5.

Central Bank policies

The Federal Reserves primarily concern was to manage the monetary policy and was least bothered about the housing bubble and dot-com bubble. Once the bubble burst, the Central Bank tried to control the spread of the crisis on other sectors. A contributing factor to the rise in home prices was the lowering of the interest rate earlier in the decade by the Federal Reserve lowered by the funds rate target from 6.5 per cent to 1 per cent. Further Greenspan has been criticized for flourishing subprime loans. (Bianco, 2008)

4.6.

Collapse of major investment banks in 2008

Major investment banks of US were collapsed due to higher risk lending. Their default rate is given in the following figure: Figure 3 Default Rate
6% 5% 4% 3% 2% 1% 0%

Source: mbaa.org, National Delinquency Survey. The default rate fluctuated, within a narrow range, around 2 percent prior to 2006.It increased only slightly during the recessions of 1982, 1990, and 2001.The rate

19 79 19 80 19 81 19 82 19 84 19 85 19 86 19 87 19 89 19 90 19 91 19 92 19 94 19 95 19 96 19 97 19 99 20 00 20 01 20 02 20 04 20 05 20 06 20 07

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began increasing sharply during the second half of 2006.It reached 5.2 percent during the third quarter of 2008.

4.7.

Short-Term Interest Rates

The Feds manipulation of interest rates during 2002-2006 and prolonged LowInterest Rate Policy of 2002-2004 increased demand for housing. The low short-term interest rates made adjustable rate loans with low down payments highly attractive. As the Fed pushed short-term interest rates upward in 2005-2006, adjustable rates were soon reset, monthly payment on these loans increased, housing prices began to fall, and defaults soared Figure 4 Federal Funds Rate and 1-Year T-Bill Rate
8% 7% 6% 5% 4% 3% 2% 1% 0%
19 95 19 95 19 96 19 96 19 97 19 97 19 98 19 99 19 99 20 00 20 00 20 01 20 02 20 02 20 03 20 03 20 04 20 04 20 05 20 06 20 06 20 07 20 07 20 08

Federal Funds

1 year T-bill

Source: www.federalreserve.gov and www.economagic.com

The Fed injected additional reserves and kept short-term interest rates at 2% or less throughout 2002-2004. Due to rising inflation in 2005, the Fed pushed interest rates upward. Interest rates on adjustable rate mortgages rose and the default rate began to increase rapidly.

4.8.

Iraq and Afghanistan War

The wars in Iraq and Afghanistan had already costed about $900 billion. U.S. banks made loans to people that could not afford to pay back the loans. A few of those banks almost went bankrupt and had to rescue by American taxpayers. So much debt had been created. All that debt caused the U.S. dollar to be weak. It took more

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dollars to buy the same stuff you could have bought with less money ten or fifteen years ago.

4.9.

Higher Leverage Ratios

An SEC Rule change adopted in April 2004 led to highly leverage lending practices by investment banks and their quick demise when default rates increased. The rule favored lending for residential housing. Loans for residential housing could be leveraged by as much as 25 to 1, and as much as 60 to 1, when bundled together and financed with securities. Based on historical default rates, mortgage loans for residential housing were thought to be safe. But this was no longer true because regulations had seriously eroded the lending standards and the low interest rates of 2002-2004 had increased the share of ARM loans with little or no down payment. When default rates increased in 2006 and 2007, the highly leveraged investment banks soon collapsed. The leverage ratios of loans and other investments to capital assets for various financial institutions are shown here Figure 5 Leverage Ratios (June 2008)
Freddie Mac Fannie Mae Brokers/hedge Funds Savings institutions Commercial banks Credit unions 0 9.4 9.8 9.1 20 40 60 80 21.5 31.6 67.9

Source: The Rise and fall of the U.S. Mortgage and Credit Markets: A Comprehensive Analysis of the Meltdown, Milken Institute

4.10. Limited Amount of Oil in America

The fact that there is a limited amount of oil in America affects the economy too. That causes the price of oil to increase the price of everything you buy in the stores because it takes gas or diesel to ship those products to the consumer. Overall, we

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can say that reckless spending and the endless war in Iraq have affected the US Economy the most.

5. Impact of US Crisis
The impact of this crisis was so severe that the United States Government had to intervene in the free market economy and had to come with $700 billion bailout package to revive the investment banks/firms and reinstate the investors faith in the stock market. The crisis has produced or exacerbated serious, wide-ranging yet differentiated impacts across the globe. Negative impacts are reported mainly from developing countries and within them some have serious problems though they did not cause the problem. The following are some impacts of this crisis: Wide spread Unemployment. The ILO predicted that at least 20 million jobs will have been lost by the end of 2009 due to the crisis, bringing world unemployment above 200 million for the first time. Deceleration of growth, economic contraction Negative effects on trade balances and balance of payments Dwindling levels of foreign direct investment (a fall of 54% in the first quarter of 2009 according to UNCTAD) Large and volatile movements in exchange rates Growing budget deficits, falling tax revenues and reduction of fiscal space Contract action of world trade Increasing volatility and falling prices for primary commodities Declining remittances to developing countries Sharply reduced revenues from tourism Massive reversal of private capital flows Reduced access to credit and trade financing Reduced public confidence in financing institutions Reduced ability to maintain social safety nets and provide other social services, such as health and education Collapse of housing markets Debt levels of main developing countries are over 150% of GDP.

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Times of economic crisis produce international tension and politicians tend to go to war rather than to face the crisis.

6. Steps Taken by US Government to Overcome the Crisis

At such times governments attempt to stimulate the economy. The US Government made different macroeconomic policies which includes policies to Increase borrowing, Reduce interest rates, Reduce taxes, and Spend on public works such as infrastructure.

6.1.

Systemic risk regulator

The purpose of a systemic risk regulator was to address the failure of any entity of sufficient scale that a disorderly failure would threaten the financial system. Such a regulator was designed to address failures of entities such as Lehman Brothers and AIG more effectively.

6.2.

Bank capital requirements & leverage restrictions

No depository banks (e.g., investment banks and mortgage companies) are not subject to the same capital requirements (or leverage restrictions) as depository banks. For example, the largest five investment banks were leveraged approximately 30:1 based on their 2007 financial statements, meaning that only a 3.33% decline in the value of their assets could make them insolvent as explained above Insurance companies such as AIG did not have sufficient capital to support the amounts they were insuring and were unable to post the required collateral as the crisis deepened.

6.3.

Short-selling restriction

Short-selling enables investors to make money when a stock or investment goes down in value. Short-sellers made enormous profits throughout the financial crisis. Therefore short selling was restricted.

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6.4. Mortgage lending regulations

Mortgage lending standards declined during the boom and complex, risky mortgage offerings were made to consumers that arguably did not understand them. At the height of the bubble in 2005, the median down payment for first-time home buyers was 2%, with 43% of those buyers making no down payment what so ever. Different regulations were imposed to control this practice.

6.5.

Financial Products Safety Commission (FPSC)

A Financial Products Safety Commission (FPSC) was established. The purpose of this commission was to review products to ensure the risks could be "safe for consumption" and effectively communicated to investors or homeowners, depending on the product.

6.6.

Increasing Authority of U.S. Federal Reserve

The authority of the US Federal Reserve was enhanced to ensure a sound financial system in the United States of America. This effectively controlled the default rate of investment banks.

6.7.

Establishment of Trade Facilitation Facility (TFF)

World Bank expanded its trade facilitation services, including the establishment of a Trade Facilitation Facility. This Facility was created to strengthen the delivery of capacity building and technical assistance in trade facilitation to low-income countries. It helped developing countries to reduce the costs of engaging in international trade and thereby take better advantage of global trade opportunities, including reaching the import standards so that their exports could successfully enter world markets.

7. Was the Crisis Avoidable?

The US Commission's final report, presented on 27 January, concluded that the crisis was "avoidable". Its causes included "widespread failures" in financial regulation and supervision as well as in corporate governance and management, which allowed the formation of an "explosive brew of excessive borrowing, risky investments and lack of transparency". The crisis itself was triggered by breaches in accountability and ethics", but key policy makers were clearly "ill prepared" for it. The

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crisis itself was avoidable and in large part it was led by government mismanagement. The Federal Reserve played a central role in enabling the crisis. It failed in its duty to set more prudent limits. Firms "made, bought and sold mortgage securities they never examined". They invested blindly and did not care if the investments were defective. Compensation "too often rewarded the quick deal, the short-term gain".

Conclusion
The US financial crisis occurred between years 2007-2009. All most every country was affected by this crisis. The causes of this crisis were housing bubble, increase of mortgage rate, increasing loan incentives, high interest rate and huge amount of loan is granted to people. These destroyed the total economy of the USA. Share market was also collapsed. Investors faced great losses and many financial institutions became bankrupted. Prices of goods and services were increased all over the world. GDP decreased, net export fell and unemployment became acute more than any time in the USA. To overcome the problems the US government as well as The U.S Federal Reserve has taken up a variety of regulatory measures such as consumer protection, executive pay, bank financial cushions or capital requirements, expanded regulation of the shadow banking system and derivatives, and enhanced authority for the Federal Reserve. But it will take time to recover from this situation. In view of the fast pace of technological and financial innovations, regulatory authorities would have to follow an approach that would have to be dynamic and adjust in response to changing economic environment.

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