Refining the Story of the Financial Crises in Europe and the USA

Yulek, Murat, Randazzo, Anthony, Insight Turkey

The financial crisis of 2007-2009 and the current economic crisis are events of historical proportions. Yet, more than three years after the global finance markets came to a screeching halt, there is still limited consensus on what caused the financial crisis.

This is to be expected, since many of the early opinions on what led to the crisis--stock market collapse, liquidity shortage, and widespread threat of bankruptcy among banks, businesses, households, and sovereigns alike--were formed before all of the data was available. As a result, many of the conventional narratives about the financial crisis contain inaccuracies or inconsistencies.

A significant amount of research has already been made about the financial crisis, so it might not seem that another primer is necessary. But the geographical distribution of the effect of the financial crisis and economic crisis is significant, extending from the USA to Europe and having bi-directional ramifications on Asia. The impact on both individual and sovereign wealth is substantial. And future investment strategy, fiscal policy, and international financial coordination will all be considered in the context of the crises.

It is, therefore, critical to fully and accurately understand the nature of the crises and their current state to ensure that the proper lessons are learned. This article aims to present a history on the causes of the financial crisis that first emerged in the U.S. in 2007. Then it will analyze the roots of the current state of the economic crisis in Europe and the U.S. It will also assess the effects of the crises on the European and American economies. A range of topics are discussed, some of which have received deeper treatment elsewhere in economic literature, but have not been pieced together to provide a coherent past and present picture of the situation. The paper will conclude with a brief comment on how this story relates to today's economic environment and the next steps that need to be taken going forward.

Definition and a Broad Chronology of the Financial Crisis

In this section, we develop a general outline of times and events that define and delineate what we mean when discussing "the financial crisis."

In August 2007, the spread between the three-month London Inter-Bank Offer Rate (Libor) and the Overnight Indexed Swap (OIS) rate spiked. (1) The Libor is primarily a measure of risk perceived by a bank when lending overnight to another bank. The OIS measures the market view of near-term risk of lending money day-today. Put simply, the Libor-OIS spread is an indicator of how the market feels about the level of risk in the system.

The spread shows that the market suddenly felt very concerned. The historical spread between the three-month Libor and OIS has been about 10 basis points (or 0.10%), but after a slow increase towards the end of July 2007, the spread hit nearly 50 basis points by August 10, 2007. By September 2007, the spread passed 90 basis points and liquidity came to a near standstill. (2) Many have identified this as the start of the financial crisis, and we agree. Figure 1 shows the Libor-OIS spread from its 2007 lull to its peak in 2008, and subsequent return to normalcy by 2009.

[FIGURE 1 OMITTED]

As we will discuss below, the reason that the Libor-OIS spread spiked was because of concerns about the subprime mortgage debt. For decades housing prices had been rising, allowing homeowners with subprime mortgages to simply sell their home if they ever became unable to make a payment. But when housing prices started to fall in 2007, the reasons of which are discussed in section 3.1, the ability to sell suddenly disappeared and very quickly a wave of mortgage defaults hit the financial system. As a result, the banks had to announce increasing high losses on their investments and assets (write-downs), with many of those losses related to toxic subprime mortgages. Total bank write-downs were $97 billion by the end of 2007, led by Citigroup with $13.2 billion in write-downs and $2.6 billion in credit losses. (3) By September 2008, those losses had reached $591 billion globally. (4)

Many of the losses experienced were directly linked to the subprime debt that had previously been labeled triple-A by the major ratings agencies. As a result, there was a complete loss of confidence in the value of assets, which, due to mark-to-market accounting rules, led to further losses and more panic.

On July 11, 2008, the Federal Deposit Insurance Corporation (FDIC) declared IndyMac Bank to be insolvent and took it into receivership. This would be the first of three bank failures in July 2008, following only three bank failures in all of 2007, and zero bank failures in 2005 and 2006. The rate of bank failures would pick up dramatically in September 2008, including a bank run on Washington Mutual (sold by the FDIC to J.P. Morgan Chase) and the failure of Wachovia (sold by FDIC to Wells Fargo).

After reaching all time highs in the summer of 2007, the leading stock indices--S&P 500, Dow Jones, and the NASDAQ--all saw between a 10 percent and 15 percent drop from July 2007 to July 2008. In September and October 2008, the stock market fell off a cliff. The Government Sponsored Enterprises (GSEs) (5) Fannie Mae and Freddie Mac were taken into conservatorship that August, followed by the failure of Lehman Brothers, a Federal Reserve bailout of A.I.G., the sale of Merrill Lynch to Bank of America, and mixed signals from the government whether or not Congress would authorize a bailout package for troubled assets. September 29, 2008 saw the largest point drop in the Dow Jones in history--a 778-point, or 7 percent decline. October 9 and 15 saw similarly shocking 7.3 percent and 7.9 percent drops respectively.

The overall slow down in financial market growth during this time period left many investors with few good places to put capital. Investors were in crisis in trying to find long-term growth potential anywhere they could justify it. Municipal governments struggled to get financing. Major corporations flirted with bankruptcy and sentiment caused consumption to contract.

After write-offs slowed in early 2009 and capital infusions came from the federal government through the TARP program, the drop off in stock prices hit a bottom in March 2009. Still, with bank failures mounting into the summer of 2009, the financial crisis pressed on. In July 2009, 24 bank failures, a peak number, occurred in one month, and in August 2009, bank failures in terms of asset size hit their post Washington Mutual peak of $43.3 billion collectively in the month. Finally the dust settled, and the Libor-OIS spread fell from its October 2008 high of roughly 350 basis points down to 10 basis points on September 18, 2009, and it remained around that range for the next eight months. Thus, we consider September 2009 to be the end of the financial crisis.

We note that this concluding timestamp will draw some criticism. Such a definition necessarily requires a concluding point, however, and though some may argue we are still in the midst of a global crisis, we chose that date to mark the end of the general sense of panic in the marketplace over financial instability in the United States. We are aware that serious problems remained following September 2009, including the quantity of bank failures in 2010, a slow growth economy in the U.S. that continues to this day, and the sovereign debt crisis in Europe with significant effects on economic growth and unemployment. But such a dramatic event as the financial crisis of this size necessarily will have decades of ripple effect, if not more, and not all can be classified as the financial crisis. In particular, we note from Reinhart and Rogoff (2009) that sovereign debt crises such as the …

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Publication information: Article title: Refining the Story of the Financial Crises in Europe and the USA. Contributors: Yulek, Murat - Author, Randazzo, Anthony - Author. Journal title: Insight Turkey. Volume: 14. Issue: 2 Publication date: Spring 2012. Page number: 59+. © 2008 SETA Foundation for Political, Economic, and Social Research. COPYRIGHT 2012 Gale Group.

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