[edit]Philippines
Further information: Economy of the Philippines
The Philippine central bank raised interest rates by 1.75 percentage points in May 1997 and again by 2 points on 19 June. Thailand triggered the crisis on 2 July and on 3 July, the Philippine Central Bank was forced to intervene heavily to defend the peso, raising the overnight rate from 15% to 32% right upon the onset of the Asian crisis in mid-July 1997. The peso fell significantly, from 26 pesos per dollar at the start of the crisis, to 38 pesos as of mid-1999, and to 54 pesos as of first half August 2001.
The Philippine economy recovered from a contraction of 0.6% in GDP during the worst part of the crisis to GDP growth of some 3% by 2001, despite scandals of the administration of Joseph Estrada in 2001, most notably the "jueteng" scandal, causing the PSE Composite Index, the main index of the Philippine Stock Exchange, to fall to some 1000 points from a high of some 3000 points in 1997. The peso fell even further, trading at levels of about 55 pesos to the US dollar. Later that year, Estrada was on the verge of impeachment but his allies in the senate voted against the proceedings to continue further. This led to popular protests culminating in the "EDSA II Revolution", which finally forced his resignation and elevated Gloria Macapagal-Arroyo to the presidency. Arroyo managed to lessen the crisis in the country, which led to the recovery of the Philippine peso to about 50 pesos by the year's end and traded at around 41 pesos to a dollar by end 2007. The stock market also reached an all time high in 2007 and the economy is growing by at least more than 7 percent, its highest in nearly 2 decades.
[edit]Hong Kong
Further information: Economy of Hong Kong
Although the two events were unrelated, the collapse of the Thai baht on 2 July 1997, came only 24 hours after the United Kingdom handed over sovereignty of Hong Kong to the People's Republic of China. In October 1997, the Hong Kong dollar, which had been pegged at 7.8 to the U.S. dollar since 1983, came under speculative pressure because Hong Kong's inflation rate had been significantly higher than the U.S.'s for years. Monetary authorities spent more than US$1 billion to defend the local currency. Since Hong Kong had more than US$80 billion in foreign reserves, which is equivalent to 700% of its M1 money supply and 45% of its M3 money supply, the Hong Kong Monetary Authority (effectively the city's central bank) managed to maintain the peg.
Stock markets became more and more volatile; between 20 October and 23 October the Hang Seng Index dropped 23%. The Hong Kong Monetary Authority then promised to protect the currency. On 15 August 1998, it raised overnight interest rates from 8% to 23%, and at one point to 500%. The HKMA had recognized that speculators were taking advantage of the city's unique currency-board system, in which overnight rates automatically increase in proportion to large net sales of the local currency. The rate hike, however, increased downward pressure on the stock market, allowing speculators to profit by short selling shares. The HKMA started buying component shares of the Hang Seng Index in mid-August.
The HKMA and Donald Tsang, then the Financial Secretary, declared war on speculators. The Government ended up buying approximately HK$120 billion (US$15 billion) worth of shares in various companies,[23] and became the largest shareholder of some of those companies (e.g. the government owned 10% of HSBC) at the end of August, when hostilities ended with the closing of the August Hang Seng Index futures contract. The Government started selling those shares in 2001, making a profit of about HK$30 billion (US$4 billion).
[edit]Malaysia
Further information: Economy of Malaysia
Before the crisis, Malaysia had a large current account deficit of 5% of its GDP. At the time, Malaysia was a popular investment destination, and this was reflected in KLSE activity which was regularly the most active stock exchange in the world (with turnover exceeding even markets with far higher capitalization like the NYSE). Expectations at the time were that the growth rate would continue, propelling Malaysia todeveloped status by 2020, a government policy articulated in Wawasan 2020. At the start of 1997, the KLSE Composite index was above 1,200, the ringgit was trading above 2.50 to the dollar, and the overnight rate was below 7%.
In July 1997, within days of the Thai baht devaluation, the Malaysian ringgit was "attacked" by speculators. The overnight rate jumped from under 8% to over 40%. This led to rating downgrades and a general sell off on the stock and currency markets. By end of 1997, ratings had fallen many notches from investment grade to junk, the KLSE had lost more than 50% from above 1,200 to under 600, and the ringgit had lost 50% of its value, falling from above 2.50 to under 4.10 to the dollar. The then premier, Mahathir Mohammad imposed strict capital controls and introduced a 3.80 peg against the US dollar
In 1998, the output of the real economy declined plunging the country into its first recession for many years. The construction sector contracted 23.5%, manufacturing shrunk 9% and the agriculture sector 5.9%. Overall, the country's gross domestic product plunged 6.2% in 1998. During that year, the ringgit plunged below 4.7 and the KLSE fell below 270 points. In September that year, various defensive measures were announced to overcome the crisis. The principal measure taken were to move the ringgit from a free float to a fixed exchange rate regime. Bank Negara fixed the ringgit at 3.8 to the dollar. Capital controls were imposed while aid offered from the IMF was refused. Various task force agencies were formed. The Corporate Debt Restructuring Committee dealt with corporate loans. Danaharta discounted and bought bad loans from banks to facilitate orderly asset realization. Danamodal recapitalized banks.
Growth then settled at a slower but more sustainable pace. The massive current account deficit became a fairly substantial surplus. Banks were better capitalized and NPLs were realised in an orderly way. Small banks were bought out by strong ones. A large number of PLCs were unable to regulate their financial affairs and were delisted. Compared to the 1997 current account, by 2005, Malaysia was estimated to have a US$14.06 billion surplus.[24] Asset values however, have not returned to their pre-crisis highs. In 2005 the last of the crisis measures were removed as the ringgit was taken off the fixed exchange system. But unlike the pre-crisis days, it did not appear to be a free float, but a managed float, like the Singapore dollar.
[edit]Singapore
Further information: Economy of Singapore
As the financial crisis spread the economy of Singapore dipped into a short recession. The short duration and milder effect on its economy was credited to the active management by the government. For example, the Monetary Authority of Singapore allowed for a gradual 20% depreciation of the Singapore dollar to cushion and guide the economy to a soft landing. The timing of government programs such as the Interim Upgrading Program and other construction related projects were brought forward. Instead of allowing the labor markets to work, the National Wage Council pre-emptively agreed to Central Provident Fund cuts to lower labor costs, with limited impact on disposable income and local demand. Unlike in Hong Kong, no attempt was made to directly intervene in the capital markets and the Straits Times Index was allowed to drop 60%. In less than a year, the Singaporean economy fully recovered and continued on its growth trajectory.[25]
[edit]China
Further information: Economy of the People's Republic of China
The Chinese currency, the renminbi (RMB), had been pegged to the US dollar at a ratio of 8.3 RMB to the dollar, in 1994. Having largely kept itself above the fray throughout 1997–1998 there was heavy speculation in the Western press that China would soon be forced to devalue its currency to protect the competitiveness of its exports vis-a-vis those of the ASEAN nations, whose exports became cheaper relative to China's. However, the RMB's non-convertibility protected its value from currency speculators, and the decision was made to maintain the peg of the currency, thereby improving the country's standing within Asia. The currency peg was partly scrapped in July 2005 rising 2.3% against the dollar, reflecting pressure from the United States.
Unlike investments of many of the Southeast Asian nations, almost all of China's foreign investment took the form of factories on the ground rather than securities, which insulated the country from rapid capital flight. While China was unaffected by the crisis compared to Southeast Asia and South Korea, GDP growth slowed sharply in 1998 and 1999, calling attention to structural problems within its economy. In particular, the Asian financial crisis convinced the Chinese government of the need to resolve the issues of its enormous financial weaknesses, such as having too many non-performing loans within its banking system, and relying heavily on trade with the United States.
[edit]United States and Japan
Further information: Economy of the United States and Economy of Japan
The "Asian flu" had also put pressure on the United States and Japan. Their markets did not collapse, but they were severely hit. On 27 October 1997, the Dow Jones industrial plunged 554 points or 7.2%, amid ongoing worries about the Asian economies. The New York Stock Exchange briefly suspended trading. The crisis led to a drop in consumer and spending confidence (see 27 October 1997 mini-crash). Japan was affected because its economy is prominent in the region. Asian countries usually run a trade deficit with Japan because the latter's economy was more than twice the size of the rest of Asia together; about 40% of Japan's exports go to Asia. The Japanese yen fell to 147 as mass selling began, but Japan was the world's largest holder of currency reserves at the time, so it was easily defended, and quickly bounced back. GDP real growth rate slowed dramatically in 1997, from 5% to 1.6% and even sank into recession in 1998, due to intense competition from cheapened rivals. The Asian financial crisis also led to more bankruptcies in Japan. In addition, with South Korea's devalued currency, and China's steady gains, many companies complained outright that they could not compete.[26]
Another longer-term result was the changing relationship between the U.S. and Japan, with the U.S. no longer openly supporting the highly artificial trade environment and exchange rates that governed economic relations between the two countries for almost five decades after World War II.[27]
[edit]Consequences
[edit]Asia
The crisis had significant macro-level effects, including sharp reductions in values of currencies, stock markets, and other asset prices of several Asian countries.[28] The nominal US dollar GDP of ASEAN fell by US$9.2 billion in 1997 and $218.2 billion (31.7%) in 1998. In South Korea, the $170.9 billion fall in 1998 was equal to 33.1% of the 1997 GDP.[29] Many businesses collapsed, and as a consequence, millions of people fell below the poverty line in 1997–1998. Indonesia, South Korea and Thailand were the countries most affected by the crisis.
Currency Exchange rate
(per US$1)[30]
Change
June 1997 July 1998
Thai baht
24.5 41 – 40.2%
Indonesian rupiah
2,380 14,150 – 83.2%
Philippine peso
26.3 42 – 37.4%
Malaysian ringgit
2.5 4.1 – 39.0%
South Korean won
850 1,290 – 34.1%
Country GNP (US$1 billion)[30]
Change
June 1997 July 1998
Thailand
170 102 – 40.0%
Indonesia
205 34 – 83.4%
Philippines
75 47 – 37.3%
Malaysia
90 55 – 38.9%
South Korea
430 283 – 34.2%

The above tabulation shows that despite the prompt raising of interest rates to 32% in the Philippines upon the onset of crisis in mid-July 1997, and to 65% in Indonesia upon the intensification of crisis in 1998, their local currencies depreciated just the same and did not perform better than those of South Korea, Thailand, and Malaysia, which countries had their high interest rates set at generally lower than 20% during the Asian crisis. This created grave doubts on the credibility of IMF and the validity of its high-interest-rate prescription to economic crisis.
The economic crisis also led to a political upheaval, most notably culminating in the resignations of President Suharto in Indonesia and Prime Minister General Chavalit Yongchaiyudh in Thailand. There was a general rise in anti-Western sentiment, with George Soros and the IMF in particular singled out as targets of criticisms. Heavy U.S. investment in Thailand ended, replaced by mostly European investment, though Japanese investment was sustained.[citation needed] Islamic and other separatist movements intensified in Southeast Asia as central authorities weakened.[31]
More long-term consequences included reversal of the relative gains made in the boom years just preceding the crisis. Nominal US dollar GDP per capital fell 42.3% in Indonesia in 1997, 21.2% in Thailand, 19% in Malaysia, 18.5% in South Korea and 12.5% in the Philippines. [29] TheCIA World Factbook reported that the per capita income (measured by purchasing power parity) in Thailand declined from $8,800 to $8,300 between 1997 and 2005; in Indonesia it declined from $4,600 to $3,700; in Malaysia it declined from $11,100 to $10,400. Over the same period, world per capita income rose from $6,500 to $9,300.[32] Indeed, the CIA's analysis asserted that the economy of Indonesia was still smaller in 2005 than it had been in 1997, suggesting an impact on that country similar to that of the Great Depression. Within East Asia, the bulk of investment and a significant amount of economic weight shifted from Japan and ASEAN to China and India.[33]
The crisis has been intensively analyzed by economists for its breadth, speed, and dynamism; it affected dozens of countries, had a direct impact on the livelihood of millions, happened within the course of a mere few months, and at each stage of the crisis leading economists, in particular the international institutions, seemed a step behind. Perhaps more interesting to economists was the speed with which it ended, leaving most of the developed economies unharmed. These curiosities have prompted an explosion of literature about financial economics and a litany of explanations why the crisis occurred. A number of critiques have been leveled against the conduct of the IMF in the crisis, including one by former World Bank economist Joseph Stiglitz. Politically there were some benefits. In several countries, particularly South Korea and Indonesia, there was renewed push for improved corporate governance. Rampaging inflation weakened the authority of the Suharto regime and led to its toppling in 1998, as well as accelerating East Timor's independence.[34]
[edit]Outside Asia
After the Asian crisis, international investors were reluctant to lend to developing countries, leading to economic slowdowns in developing countries in many parts of the world. The powerful negative shock also sharply reduced the price of oil, which reached a low of $8 per barreltowards the end of 1998, causing a financial pinch in OPEC nations and other oil exporters. This reduction in oil revenue contributed to the 1998 Russian financial crisis, which in turn caused Long-Term Capital Management in the United States to collapse after losing $4.6 billion in 4 months. A wider collapse in the financial markets was avoided when Alan Greenspan and the Federal Reserve Bank of New York organized a $3.625 billion bail-out. Major emerging economies Brazil and Argentina also fell into crisis in the late 1990s (see Argentine debt crisis).[35]
The crisis in general was part of a global backlash against the Washington Consensus and institutions such as the IMF and World Bank, which simultaneously became unpopular in developed countries following the rise of the anti-globalization movement in 1999. Four major rounds of world trade talks since the crisis, in Seattle, Doha, Cancún, and Hong Kong, have failed to produce a significant agreement as developing countries have become more assertive, and nations are increasingly turning toward regional or bilateral FTAs (Free Trade Agreements) as an alternative to global institutions. Many nations learned from this, and quickly built up foreign exchange reserves as a hedge against attacks, including Japan, China, South Korea. Pan Asian currency swaps were introduced in the event of another crisis. However, interestingly enough, such nations as Brazil, Russia, and India as well as most of East Asia began copying the Japanese model of weakening their currencies, restructuring their economies so as to create a current account surplus to build large foreign currency reserves. This has led to an ever increasing funding for US treasury bonds, allowing or aiding housing (in 2001–2005) and stock asset bubbles (in 1996–2000) to develop in the United States.
[edit]See also
 Financial crisis
 Financial contagion
 List of finance topics
[edit]Notes
1. ^ Kaufman: pp. 195–6
2. ^ http://www.adb.org/Documents/Books/Key_Indicators/2003/pdf/rt29.pdf
3. ^ Pempel: pp 118–143
4. ^ The Myth of Asia's Miracle A Cautionary Fable by Paul Krugman.
5. ^ Hughes, Helen. Crony Capitalism and the East Asian Currency Financial 'Crises'. Policy. Spring 1999.
6. ^ Blustein: p. 73
7. ^ The Three Routes to Financial Crises: The Need for Capital Controls. Gabriel Palma (Cambridge University). Center for Economic Policy Analysis. November 2000.
8. ^ Bernard Eccleston, Michael Dawson, Deborah J. McNamara (1998). The Asia-Pacific Profile. Routledge (UK). ISBN 0415172799.
9. ^ FIRE-SALE FDI by Paul Krugman.
10. ^ Stiglitz: pp. 12–16
11. ^ Joint Comminuque The 30th ASEAN Ministerial Meeting (AMM) The Thirtieth ASEAN Ministerial Meeting was held in Subang Jaya, Malaysia from 24 to 25 July 1997.
12. ^ Halloran, Richard. China's Decisive Role in the Asian Financial Crisis. Global Beat Issue Brief No. 24. 27 January 1998.
13. ^ Noland: pp. 98–103
14. ^ a b IMF's Role in the Asian Financial Crisis by Walden Bello.
15. ^ The IMF Crisis Editorial. Wall Street Journal. 15 April 1998.
16. ^ http://www.columbia.edu/cu/thai/html/financial97_98.html
17. ^ Kaufman: pp. 193–8
18. ^ Liebhold, David. Thailand's Scapegoat? Battling extradition over charges of embezzlement, a financier says he's the fall guy for the 1997 financial crash. TIME.com. 27 December 1999.
19. ^ Pressure from below: Supporters of the new, improved Constitution now have to help turn words into action 10 October 1997
20. ^ "Japan Stocks Slide Again On Fears About Stability". Wall Street Journal Online. 26 December 1997. Retrieved 2 September 2009.
21. ^ http://www.oanda.com/convert/fxhistory August 13 = 2673; August 14 = 2790; August 15 = 2900; August 31 = 2930; October 31 = 3640; December 31 = 5535. Accessed 2009-08-20. Archived 2009-09-04.
22. ^ http://www.oanda.com/convert/fxhistory January 31 = 10,100; March 31 = 8,650; May 31 = 11,350; July 31 = 13,250; September 30 = 10,800. Accessed 2009-08-20. Archived 2009-09-04.
23. ^ Bayani Cruz, We will hold on to blue-chip shares: Tsang, The Standard, 29 August 1998.
24. ^ The CIA World Factbook - Malaysia
25. ^ Ngian Kee Jin: p. 12
26. ^ Pettis: pp. 55–60
27. ^ Pettis: p. 79
28. ^ Tiwari: pp. 1–3
29. ^ a b http://www.adb.org/Documents/Books/Key_Indicators/2001/rt11_ki2001.xls
30. ^ a b Cheetham, R. 1998. Asia Crisis. Paper presented at conference, U.S.-ASEAN-Japan policy Dialogue. School of Advanced International Studies of Johns Hopkins University, June 7–9, Washington, D.C.
31. ^ Radelet: pp. 5–6
32. ^ The Asian financial crisis ten years later: assessing the past and looking to the future. Janet L. Yellen. Speech to the Asia Society of Southern California, Los Angeles, California, 6 February 2007
33. ^ Kilgour, Andrea (1999). The changing economic situation in Vietnam: A product of the Asian crisis?
34. ^ Weisbrot: p. 6
35. ^ The Crash transcript. PBS Frontline.
[edit]References
[edit]Books
 Kaufman, GG., Krueger, TH., Hunter, WC. (1999) The Asian Financial Crisis: Origins, Implications and Solutions. Springer. ISBN 0792384725
 Pettis, Michael (2001). The Volatility Machine: Emerging Economies and the Threat of Financial Collapse. Oxford University Press. ISBN 0-19-514330-2.
 Blustein, Paul (2001). The Chastening: Inside the Crisis that Rocked the Global Financial System and Humbled the IMF. PublicAffairs.ISBN 1-891620-81-9.
 Noland, Markus, Li-gang Liu, Sherman Robinson, and Zhi Wang. (1998) Global Economic Effects of the Asian Currency Devaluations. Policy Analyses in International Economics, no. 56. Washington, DC: Institute for International Economics.
 Pempel, T. J. (1999) The Politics of the Asian Economic Crisis. Ithaca, NY: Cornell University Press.
 Ries, Philippe. (2000) The Asian Storm: Asia's Economic Crisis Examined.
 Tecson, Marcelo L. (2005) Puzzlers: Economic Sting (The Case Against IMF, Central Banks, and IMF-Prescribed High Interest Rates) Makati City, Philippines: Raiders of the Lost Gold Publication
 Muchhala, Bhumika, ed. (2007) Ten Years After: Revisiting the Asian Financial Crisis[1]. Washington, DC: Woodrow Wilson International Center for Scholars Asia Program.
 Ito, Takatoshi and Andrew K. Rose (2006). Financial Sector Development in the Pacific Rim. University of Chicago Press. ISBN 9780226386843.
[edit]Papers
 Ngian Kee Jin (March 2000). Coping with the Asian Financial Crisis: The Singapore Experience. Institute of Southeast Asian Studies. ISSN 0219-3582
 Tiwari, Rajnish (2003). Post-crisis Exchange Rate Regimes in Southeast Asia, Seminar Paper, University of Hamburg.
 Kilgour, Andrea (1999). The changing economic situation in Vietnam: A product of the Asian crisis?
 S. Radelet, J.D. Sachs, R.N. Cooper, B.P. Bosworth (1998). The East Asian Financial Crisis: Diagnosis, Remedies, Prospects. Brookings Papers on Economic Activity.
 Stiglitz, Joseph (1996). Some Lessons From The East Asian Miracle. The World Bank Research Observer.
 Weisbrot, Mark (August 2007). Ten Years After: The Lasting Impact of the Asian Financial Crisis. Center for Economic and Policy Research.
 Tecson, Marcelo L. (2009), "IMF Must Renounce Its Weapon of Mass Destruction: High Interest Rates" (4-part paper on high-interest-rate fallacies and alternatives, emailed to IMF and others on January 27, 2009)
[edit]Other
 Is Thailand on the road to recovery, article by Australian photo-journalist John Le Fevre that looks at the effects of the Asian Economic Crisis on Thailand's construction industry
 Women bear brunt of crisis, article by Australian photo-journalist John Le Fevre examining the effects of the Asian Economic Crisis on Asia's female workforce
 The Crash (transcript only), from the PBS series Frontline

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This article is about background financial market events dating from July 2007. For an overview of all economic problems during the late 2000s, see Late 2000s recession.
Part of a series on:
2007–2009 financial crisis
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 Iceland
 Ireland
 Latvia
 Russia
 Spain

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Causes[show]

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v • d • e

The financial crisis of 2007–2009 has been called the worst financial crisis since the one related to the Great Depression by leading economists,[1] and it contributed to the failure of key businesses, declines in consumer wealth estimated in the trillions of U.S. dollars, substantial financial commitments incurred by governments, and a significant decline in economic activity.[2] Many causes have been proposed, with varying weight assigned by experts.[3] Both market-based and regulatory solutions have been implemented or are under consideration,[4] while significant risks remain for the world economy.[5]
Contents
[hide]
• 1 Background and causes
o 1.1 Growth of the housing bubble
o 1.2 Easy credit conditions
o 1.3 Sub-prime lending
o 1.4 Predatory lending
o 1.5 Deregulation
o 1.6 Increased debt burden or over-leveraging
o 1.7 Financial innovation and complexity
o 1.8 Credit Ratings
o 1.9 Boom and collapse of the shadow banking system
o 1.10 Commodity bubble
o 1.11 Systemic crisis
o 1.12 Role of economic forecasting
• 2 Financial markets impacts
o 2.1 Impacts on financial institutions
o 2.2 Credit markets and the shadow banking system
o 2.3 Wealth effects
o 2.4 Global contagion
• 3 Effects on the global economy
o 3.1 Global effects
o 3.2 U.S. economic effects
o 3.3 Official economic projections
• 4 Responses to financial crisis
o 4.1 Emergency and short-term responses
o 4.2 Regulatory proposals and long-term responses
• 5 See also
• 6 References
• 7 External links and further reading

[edit]Background and causes
The immediate cause or trigger of the crisis was the bursting of the United States housing bubble which peaked in approximately 2005–2006.[6][7] High default rates on "subprime" and adjustable rate mortgages (ARM), began to increase quickly thereafter. 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 2006–2007 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.


Share in GDP of U.S. financial sector since 1860.[8]
In the years leading up to the start of the crisis in 2007, significant amounts of foreign money flowed into the U.S. from fast-growing economies in Asia and oil-producing countries. This inflow of funds made it easier for the Federal Reserve to keep interest rates in the United States too low (by the Taylor rule) from 2002–2006 which contributed to easy credit conditions, leading to the United States housing bubble. Loans of various types (e.g., mortgage, credit card, and auto) were easy to obtain and consumers assumed an unprecedented debt load.[9][10] As part of the housing and credit booms, the amount of financial agreements called mortgage-backed securities (MBS), which derive their value from mortgage payments and housing prices, greatly increased. Such financial innovation enabled institutions and investors around the world to invest in the U.S. housing market. As housing prices declined, major global financial institutions that had borrowed and invested heavily in subprime MBS reported significant losses. Falling prices also resulted in homes worth less than the mortgage loan, providing a financial incentive to enter foreclosure. The ongoing foreclosure epidemic that began in late 2006 in the U.S. continues to drain wealth from consumers and erodes the financial strength of banking institutions. Defaults and losses on other loan types also increased significantly as the crisis expanded from the housing market to other parts of the economy. Total losses are estimated in the trillions of U.S. dollars globally.[11]
While the housing and credit bubbles built, a series of factors caused the financial system to both expand and become increasingly fragile. Policymakers did not recognize the increasingly important role played by financial institutions such as investment banks and hedge funds, also known as the shadow banking system. Some experts believe these institutions had become as important as commercial (depository) banks in providing credit to the U.S. economy, but they were not subject to the same regulations.[12] These institutions as well as certain regulated banks had also assumed significant debt burdens while providing the loans described above and did not have a financial cushion sufficient to absorb large loan defaults or MBS losses.[13] These losses impacted the ability of financial institutions to lend, slowing economic activity. Concerns regarding the stability of key financial institutions drove central banks to provide funds to encourage lending and restore faith in thecommercial paper markets, which are integral to funding business operations. Governments also bailed out key financial institutions and implemented economic stimulus programs, assuming significant additional financial commitments.
[edit]Growth of the housing bubble
Main article: United States housing bubble
Between 1997 and 2006, the price of the typical American house increased by 124%.[14] During the two decades ending in 2001, the national median home price ranged from 2.9 to 3.1 times median household income. This ratio rose to 4.0 in 2004, and 4.6 in 2006.[15] This housing bubble resulted in quite a few homeowners refinancing their homes at lower interest rates, or financing consumer spending by taking out second mortgages secured by the price appreciation.
Free cash used by consumers from home equity extraction doubled from $627 billion in 2001 to $1,428 billion in 2005 as the housing bubble built, a total of nearly $5 trillion dollars over the period, contributing to economic growth worldwide.[16][17][18] U.S. home mortgage debt relative to GDP increased from an average of 46% during the 1990s to 73% during 2008, reaching $10.5 trillion.[19]
By September 2008, average U.S. housing prices had declined by over 20% from their mid-2006 peak.[20][21] Easy credit, and a belief that house prices would continue to appreciate, had encouraged many subprime borrowers to obtain adjustable-rate mortgages.[dubious – discuss]These mortgages enticed borrowers with a below market interest rate for some predetermined period, followed by market interest rates for the remainder of the mortgage's term. Borrowers who could not make the higher payments once the initial grace period ended would try to refinance their mortgages. Refinancing became more difficult, once house prices began to decline in many parts of the USA. Borrowers who found themselves unable to escape higher monthly payments by refinancing began to default. During 2007, lenders had begun foreclosure proceedings on nearly 1.3 million properties, a 79% increase over 2006.[22] This increased to 2.3 million in 2008, an 81% increase vs. 2007.[23]As of August 2008, 9.2% of all mortgages outstanding were either delinquent or in foreclosure.[24]
[edit]Easy credit conditions
From 2000 to 2003, the Federal Reserve lowered the federal funds rate target from 6.5% to 1.0%.[25] This was done to soften the effects of the collapse of the dot-com bubble and of the September 2001 terrorist attacks, and to combat the perceived risk of deflation.[26] The Fed then raised the Fed funds rate significantly between July 2004 and July 2006.[27] This contributed to an increase in 1-year and 5-year adjustable-rate mortgage (ARM) rates, making ARM interest rate resets more expensive for homeowners.[28] This may have also contributed to the deflating of the housing bubble, as asset prices generally move inversely to interest rates and it became riskier to speculate in housing.[29][30]


U.S. Current Account or Trade Deficit
In 2005, Ben Bernanke addressed the implications of the USA's high and rising current account (trade) deficit, resulting from USA imports exceeding its exports.[31] Between 1996 and 2004, the USA current account deficit increased by $650 billion, from 1.5% to 5.8% of GDP. Financing these deficits required the USA to borrow large sums from abroad, much of it from countries running trade surpluses, mainly the emerging economies in Asia and oil-exporting nations. The balance of payments identity requires that a country (such as the USA) running a current account deficit also have a capital account (investment) surplus of the same amount. Hence large and growing amounts of foreign funds (capital) flowed into the USA to finance its imports. This created demand for various types of financial assets, raising the prices of those assets while lowering interest rates. Foreign investors had these funds to lend, either because they had very high personal savings rates (as high as 40% in China), or because of high oil prices. Bernanke referred to this as a "saving glut."[32] A "flood" of funds (capital or liquidity) reached the USA financial markets. Foreign governments supplied funds by purchasing USA Treasury bonds and thus avoided much of the direct impact of the crisis. USA households, on the other hand, used funds borrowed from foreigners to finance consumption or to bid up the prices of housing and financial assets. Financial institutions invested foreign funds in mortgage-backed securities. USA housing and financial assets dramatically declined in value after the housing bubble burst.[33][34]
[edit]Sub-prime lending


U.S. Subprime lending expanded dramatically 2004-2006
In addition to easy credit conditions, there is evidence that both government and competitive pressures contributed to an increase in the amount of subprime lending during the years preceding the crisis. Major U.S. investment banks and government sponsored enterprises like Fannie Mae[dubious – discuss] played an important role in the expansion of higher-risk lending.[35][36]
The term subprime refers to the credit quality of particular borrowers, who have weakened credit histories and a greater risk of loan default than prime borrowers.[37] The value of U.S. subprime mortgages was estimated at $1.3 trillion as of March 2007,[38] with over 7.5 million first-lien subprime mortgages outstanding.[39]
Subprime mortgages remained below 10% of all mortgage originations until 2004, when they spiked to nearly 20% and remained there through the 2005-2006 peak of the United States housing bubble.[40] A proximate event to this increase was the April 2004 decision by the U.S. Securities and Exchange Commission (SEC) to relax the net capital rule, which encouraged the largest five investment banks to dramatically increase their financial leverage and aggressively expand their issuance of mortgage-backed securities. This applied additional competitive pressure to Fannie Mae and Freddie Mac, which further expanded their riskier lending.[41] Subprime mortgage payment delinquency rates remained in the 10-15% range from 1998 to 2006[42], then began to increase rapidly, rising to 25% by early 2008.[43][44]
Some, like American Enterprise Institute fellow Peter J. Wallison[45], believe the roots of the crisis can be traced directly to sub-prime lending by Fannie Mae and Freddie Mac, which are government sponsored entities. On 30 September 1999, The New York Times reported that the Clinton Administration pushed for sub-prime lending: "Fannie Mae, the nation's biggest underwriter of home mortgages, has been under increasing pressure from the Clinton Administration to expand mortgage loans among low and moderate income people...In moving, even tentatively, into this new area of lending, Fannie Mae is taking on significantly more risk, which may not pose any difficulties during flush economic times. But the government-subsidized corporation may run into trouble in an economic downturn, prompting a government rescue similar to that of the savings and loan industry in the 1980s."[46]
In 1995, the administration also tinkered with President Jimmy Carter's Community Reinvestment Act of 1977 by regulating and strengthening the anti-redlining procedures. The result was a push by the administration for greater investment, by financial institutions, into riskier loans. A 2000 United States Department of the Treasury study of lending trends for 305 cities from 1993 to 1998 showed that $467 billion of mortgage credit poured out of CRA-covered lenders into low and mid level income borrowers and neighborhoods.[47]
Others have pointed out that there were not enough of these loans made to cause a crisis of this magnitude. In an article in Portfolio Magazine,Michael Lewis spoke with one trader who noted that "There weren’t enough Americans with [bad] credit taking out [bad loans] to satisfy investors’ appetite for the end product." Essentially, investment banks and hedge funds used financial innovation to synthesize more loans using derivatives. "They were creating [loans] out of whole cloth. One hundred times over! That’s why the losses are so much greater than the loans."[48]
[edit]Predatory lending
Predatory lending refers to the practice of unscrupulous lenders, to enter into "unsafe" or "unsound" secured loans for inappropriate purposes.[49] A classic bait-and-switch method was used by Countrywide, advertising low interest rates for home refinancing. Such loans were written into extensively detailed contracts, and swapped for more expensive loan products on the day of closing. Whereas the advertisement might state that 1% or 1.5% interest would be charged, the consumer would be put into an adjustable rate mortgage (ARM) in which the interest charged would be greater than the amount of interest paid. This created negative amortization, which the credit consumer might not notice until long after the loan transaction had been consummated.
Countrywide, sued by California Attorney General Jerry Brown for "Unfair Business Practices" and "False Advertising" was making high cost mortgages "to homeowners with weak credit, adjustable rate mortgages (ARMs) that allowed homeowners to make interest-only payments."[50]. When housing prices decreased, homeowners in ARMs then had little incentive to pay their monthly payments, since their home equity had disappeared. This caused Countrywide's financial condition to deteriorate, ultimately resulting in a decision by the Office of Thrift Supervision to seize the lender.
Countrywide, according to Republican Lawmakers, had involved itself in making low-cost loans to politicians, for purposes of gaining political favors.[51].
Former employees from Ameriquest, which was United States's leading wholesale lender,[52] described a system in which they were pushed to falsify mortgage documents and then sell the mortgages to Wall Street banks eager to make fast profits.[52] There is growing evidence that such mortgage frauds may be a cause of the crisis.[52]
[edit]Deregulation
Further information: Government policies and the subprime mortgage crisis
Critics have argued that the regulatory framework did not keep pace with financial innovation, such as the increasing importance of the shadow banking system, derivatives and off-balance sheet financing. In other cases, laws were changed or enforcement weakened in parts of the financial system. Key examples include:
 In October 1982, President Ronald Reagan signed into Law the Garn-St. Germain Depository Institutions Act, which began the process of Banking deregulation that helped contribute to the savings and loan crises of the late 80's/early 90's, and the financial crises of 2007-2009. President Reagan stated at the signing, "all in all, I think we hit the jackpot".[53]
 In November 1999, President Bill Clinton signed into Law the Gramm-Leach-Bliley Act, which repealed part of the Glass-Steagall Act of 1933. This repeal has been criticized for reducing the separation between commercial banks (which traditionally had a conservative culture) and investment banks (which had a more risk-taking culture).[54][55]
 In 2004, the Securities and Exchange Commission relaxed the net capital rule, which enabled investment banks to substantially increase the level of debt they were taking on, fueling the growth in mortgage-backed securities supporting subprime mortgages. The SEC has conceded that self-regulation of investment banks contributed to the crisis.[56][57]
 Financial institutions in the shadow banking system are not subject to the same regulation as depository banks, allowing them to assume additional debt obligations relative to their financial cushion or capital base.[58] This was the case despite the Long-Term Capital Management debacle in 1998, where a highly-leveraged shadow institution failed with systemic implications.
 Regulators and accounting standard-setters allowed depository banks such as Citigroup to move significant amounts of assets and liabilities off-balance sheet into complex legal entities called structured investment vehicles, masking the weakness of the capital base of the firm or degree of leverage or risk taken. One news agency estimated that the top four U.S. banks will have to return between $500 billion and $1 trillion to their balance sheets during 2009.[59] This increased uncertainty during the crisis regarding the financial position of the major banks.[60] Off-balance sheet entities were also used by Enron as part of the scandal that brought down that company in 2001.[61]
 As early as 1997, Fed Chairman Alan Greenspan fought to keep the derivatives market unregulated.[62] With the advice of the President's Working Group on Financial Markets,[63] the U.S. Congress and President allowed the self-regulation of the over-the-counter derivatives market when they enacted the Commodity Futures Modernization Act of 2000. Derivatives such as credit default swaps (CDS) can be used to hedge or speculate against particular credit risks. The volume of CDS outstanding increased 100-fold from 1998 to 2008, with estimates of the debt covered by CDS contracts, as of November 2008, ranging from US$33 to $47 trillion. Total over-the-counter (OTC) derivative notional value rose to $683 trillion by June 2008.[64] Warren Buffett famously referred to derivatives as "financial weapons of mass destruction" in early 2003.[65][66]
[edit]Increased debt burden or over-leveraging


Leverage Ratios of Investment Banks Increased Significantly 2003-2007
U.S. households and financial institutions became increasingly indebted or overleveraged during the years preceding the crisis. This increased their vulnerability to the collapse of the housing bubble and worsened the ensuing economic downturn. Key statistics include:
 USA household debt as a percentage of annual disposable personal income was 127% at the end of 2007, versus 77% in 1990.[67]
 U.S. home mortgage debt relative to gross domestic product (GDP) increased from an average of 46% during the 1990s to 73% during 2008, reaching $10.5 trillion.[19]
 In 1981, U.S. private debt was 123% of GDP; by the third quarter of 2008, it was 290%.[68]
 From 2004-07, the top five U.S. investment banks each significantly increased their financial leverage (see diagram), which increased their vulnerability to a financial shock. These five institutions reported over $4.1 trillion in debt for fiscal year 2007, about 30% of USA nominal GDP for 2007. Lehman Brothers was liquidated, Bear Stearns andMerrill Lynch were sold at fire-sale prices, and Goldman Sachs and Morgan Stanley became commercial banks, subjecting themselves to more stringent regulation. With the exception of Lehman, these companies required or received government support.[69]
 Fannie Mae and Freddie Mac, two U.S. Government sponsored enterprises, owned or guaranteed nearly $5 trillion in mortgage obligations at the time they were placed into conservatorship by the U.S. government in September 2008.[70][71]
These seven entities were highly leveraged and had $9 trillion in debt or guarantee obligations, an enormous concentration of risk, yet were not subject to the same regulation as depository banks.