FINANCIAL CRISES

DUE TO POLICY FAILURE

Financial Crisis: - A worldwide period of economic difficulty experienced by

markets and consumers. A global financial crisis is a difficult business environment
to succeed in since potential consumers tend to reduce their purchases of goods and
services until the economic situation improves.
It has the following types:
Banking Crisis
Currency Crisis
Speculative Crisis
International Financial Crisis
Wider Economic Crisis

The financial crisis of 20072008 is considered by many economists to have been

the worst financial crisis since the Great Depression of the 1930s.
Many factors contribute in the crisis, one of them is financial crisis due to Policy
Failure. Government failure had a leading role in creating the conditions that led to
the crash
The financial crises was the result of government housing policy By 2008 there
were approximately 28 million weak mortgages in the financial system and among
them 20.4 million were in the books of government agency like Fannie Mae and
Freddie Mac and other government agencies and banks that were holding them as a
result of the requirements of community reinvestment act. Without government
housing policy there would never have been a financial crises
Background
The first sign that the economy was in trouble occurred in 2006. That's when housing
prices started to fall. At first, realtors applauded. They thought the overheated housing
market would return to a more sustainable level.

Realtors didn't realize there were too many homeowners with questionable credit. Banks
had allowed people to take out loans for 100 percent or more of the value of their new
homes. Many blamed the Community Reinvestment Act. It pushed banks to make loans
in subprime areas, but that wasn't the underlying cause.

The Gramm-Rudman Act was the real villain. It allowed banks to engage in trading
profitable derivatives that they sold to investors. These mortgage-backed
securities needed mortgages as collateral. The derivatives created an insatiable demand
for more and more mortgages.

The Federal Reserve believed the subprime mortgage crisis would only hurt housing.

It didn't know how far the damage would spread. That's because it didn't understand the
true causes of the subprime mortgage crisis until later.

Hedge funds and other financial institutions around the world owned the mortgage-
backed securities. The securities were also in mutual funds, corporate assets and pension
funds.

The banks had chopped up the original mortgages and resold them in tranches. That
made the derivatives impossible to price.

Why did stodgy pension funds buy such risky assets? They thought an insurance product
called credit default swaps protected them. A traditional insurance company known
as AIG sold these swaps. When the derivatives lost value, AIG didn't have enough cash
flow to honor all the swaps.

Banks panicked when they realized they would have to absorb the losses. They stopped
lending to each other. They didn't want other banks giving them worthless mortgages as
collateral. No one wanted to get stuck holding the bag. As a result, interbank borrowing
costs (known as LIBOR) rose. This mistrust within the banking community was the
primary cause of the 2008 financial crisis,
Costs

In 2007, the Federal Reserve began pumping liquidity into the banking system via
the Term Auction Facility. Looking back, it's hard to see how they missed the early clues
in 2007.

The Fed's actions weren't enough. In March 2008, investors went after investment
bank Bear Stearns. Rumors circulated that it had too many of these by-now toxic assets.
Bear approached JP Morgan Chase to bail it out. The Fed had to sweeten the deal with a
$30 billion guarantee.

Wall Street thought the panic was over.

Instead, the situation deteriorated throughout the summer of 2008. The Treasury
Department was authorized to spend up to $150 billion to subsidize and eventually take
over Fannie Mae and Freddie Mac. The Fed used $85 billion to bail out AIG. This later
rose to $150 billion.

On September 19, 2008, the crisis created a run on ultra-safe money market funds. That's
where most companies put any excess cash they might have accrued by the end of the
day. They can earn a little interest on it before they need it again. Banks use those funds
to make short-term loans.

Throughout the day, businesses moved a record $140 billion out of their money market
accounts into even safer Treasury bonds. If these accounts went bankrupt, business
activities and the economy would grind to a halt.

Treasury Secretary Henry Paulson conferred with Fed Chair Ben Bernanke. They
submitted to Congress a $700 billion bailout package. Their fast response reassured
businesses to keep their money in the money market accounts.

Republicans blocked the bill for two weeks. They didn't want to bail out banks. They
didn't approve the bill until global stock markets almost collapsed. For more details,
see 2008 Financial Crisis Timeline.

But the bailout package never really cost the taxpayer the full $700 billion. The Treasury
Department only used $350 billion to buy bank and automotive company stocks, when
the prices were low. By 2010, banks had paid back $194 billion into the TARP fund.

The other $350 billion was for President Obama, who never used it. Instead, he launched
the $787 billion Economic Stimulus package. That put money directly into the economy
instead of the banks. For more, see 2009 Financial Crisis Timeline.
There were Number of mistakes in Policy which led
to Financial Crises in 2007-2008
Central banks created a monetary bubble that fed an asset price boom and
distorted the pricing of risk.
US government policy encouraged high-risk lending through support for Fannie
Mae and Freddie Mac (which had explicit government targets of providing over
50pc of mortgage finance to poor households) and through the Community
Reinvestment Act and related regulations.
Regulators and central bankers failed to use their considerable powers to stop
risks building up in the financial system and an extension of regulation will not
make a future crash less likely.
Much existing banking regulation exacerbated the crisis and reduced the
effectiveness of market monitoring of banks. The FSA, in the UK, has failed in its
statutory duty to maintain market confidence.
The tax and regulatory systems encourage complex and opaque methods of
increasing gearing in the financial system.
Financial institutions that have made mistakes have lost the majority of their
value. On the other hand, regulators are being rewarded for failure by an extension
of their size and powers.
Evidence suggests that serious systemic problems have not arisen amongst
unregulated institutions.
Is it possible for it to occur in near future again?
Many legislators blame Fannie and Freddie for the entire crisis. To them, the
solution is to close or privatize the two agencies. But if they were shut down, the
housing market would collapse. That's because they guarantee 90 percent of all
mortgages. Furthermore, securitization (bundling and reselling loans) has spread to
more than just housing.
The government must step in to regulate. Congress passed the Dodd-Frank Wall
Street Reform Act to prevent banks from taking on too much risk. It allows the Fed
to reduce bank size for those that become too big to fail.
But it left many of the measures up to federal regulators to sort out the details.
Meanwhile, banks keep getting bigger and are pushing to get rid of even this
regulation. The financial crisis of 2008 proved that banks cannot regulate
themselves. Without government oversight like Dodd-Frank, they could create
another global crisis.