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The Current Global Financial Crisis

The Current Global Financial Crisis has its roots in the real estate boom gripping the United States and Europe from 2002-03 onwards.

Rising house prices, easy credit terms with special provisions in the initial financing tenure and a welcoming attitude by financial institutions to people with short or no credit histories attracted Americans and their European counterparts to take out mortgages on the belief that by the time the softer periods wore out, house prices would have increased considerably to allow the them to refinance the mortgage at lower rates or that incomes would have risen considerably to take advantage of adjustable rate mortgages (ARM) options.

However, decline in house prices in late 2006 and early 2007 meant that although the softer periods had worn out, expectations had not materialized. With ARM options being excercised increasingly, and a bleak economic outlook precluding any sizeable chance of house prices rebounding in the near short term, the defaults started as more and more homeowners found it difficult to make payments resulting in more pressure on the housing market. To add to the vows of the world economy, the development of financial markets over the years had introduced securitization and derivatives, arguably “weapons of mass destruction”.

Where securitization allowed banks to convert normal mortgages into mortgage backed seurities (MBS) and collataralized debt obligations (CDO) and sell them to their peers and the public (which included not only Americans but pension funds in Norway and investment management firms in Australia, to a name a few) thus allowing them to take off bad quality debt off their balance sheets so as to maintain a healthy outlook, derivavtive contracts, esp Credit Default Swaps (CDS) allowed this very public to hedge against the risk of default on their investments.

Thus, when the defaults did occur, the exposure that they had was massive. The whole interlinked chain meant that financial institutions found themselves unable to cover the losses on their own investments plus having to honour commitments to credit default swap contract holders. Following massive losses on there mortgage backed assets, these financial institutions suffered a loss of investor and public confidence as fears mounted that following the mortgage portfolio crash and given the high level of debt that individuals hold, Financial institutions stood little chance of survival.

While panic stricken depsoitors withdrew their money, inter bank lending also dried up as peer banks also became weary of lending to their counterparts facing liquidity issues. A general hysteria developed as financial institutions grew ever more afraid of the extent of toxic mortgage related assets on their own balance sheets and stopped lending and chose to sit on their capital reserves.

This credit crunch effected the American economy as a loss of confidence and lack of fresh credit disbursements propelled the a slow down in economic activity, ultimately leading to a recession in America. (Irfan, 2008) The fact that America acts as a demand generator for the rest of the world further aggravated issues as low demand led to corresponding production and employment decisions the world over leading to an overall slowdown in the global economy and hence pushing the world towards a recession. (The Economist Intelligence Unit, 2009)

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