The Financial Crisis- paper

The Financial Crisis
Philippe De Smit
3rd Bachelor Commercial Engineer
FUNDP 2008-2009


Philippe De Smit
rd
3 Bachelor Commercial Engineer
FUNDP 2008-2009

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INDEX

I. Introduction ................................................................................................. 4

II. Causes of the current financial crisis .......................................................... 5

III. A timeline of the most important events..................................................... 8

IV. Fannie and Freddie.................................................................................... 11

V. The current financial crisis’ nature ........................................................... 13

VI. The great depression & lessons from the past .......................................... 14

VII. The Impact on Emerging Countries. ......................................................... 19

VIII. How to solve this problem ........................................................................ 24

IX. Executive Summary .................................................................................. 28

X. Sources ...................................................................................................... 29

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I. Introduction
“Fears drag down European markets”,” Pound tumbles to a five-year low”, “Credit crisis,
world in turmoil”, etc. The major news-topic during last months was the Financial Crisis. All
over the world, there are a lot of questions about the origins of this crisis.

In this paper I am going to explain to you what the financial crisis is. We are going to look for
the origins of this crisis, but not for the responsibilities. I will make a comparison to previous
major financial crises, shaping a view of which lessons we should have learned from the past.
After that, we will look at the consequences this crisis has on the emerging countries’
economies.

A short definition of the financial crisis can be: “A loss of confidence in a country's currency
or other financial assets causing international investors to withdraw their funds from the
country”11 The current financial crisis can be defined as a situation in which a large part of
financial institutions or assets suddenly lost a substantial chunk of their value. In the 19th and
early 20th century, many financial crises were associated with banking panics and recessions
coincided with these panics. Banking panics, recessions...these words still have their
importance when we talk about the current financial crisis. But the current financial crisis is
more complex: it is not just caused by recession or by banking panics, but also by the mania
for home ownership, by speculative fever, by the crash of the dot-com bubble, by historically
low interest rates and the risky mortgage products and by lax lending standards. Annex 1
gives an overview of the different events that caused the final financial crisis, while annex 4
gives a graphical overview.

I especially want to thank Jean Sanders (securities house Petercam) for supporting & advising
me.

The Chinese use two brush strokes to write the word 'crisis'. One brush stroke stands for danger; the
other for opportunity. In a crisis, be aware of the danger-but recognize the opportunity.

~ John F. Kennedy

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II. Causes of the current financial crisis
The crisis started in the US housing markets. The main problem was the lack of transparency
in financial markets: there was no real control on new financial products such as mortgage-
backed securities. Mortgage-problems became more apparent throughout 2007 and 2008.

For a number of years, a declined lending
“The only reason I made a commercial for
standard and an increase in loan incentives
American Express was to pay for my American
(such as easy initial terms, and a long-term Express bill.", Peter Ustinov.
trend of rising housing prices) had encouraged
many good American house-father to assume (difficult) mortgages in the belief they would be
able to quickly refinance at more favourable terms. A good example is the image everyone
has of the American with a bunch of credit cards in his wallet: Americans don’t know how to
save money, if they earn money; they want to spend it as soon as possible. Stronger, they even
want to spend money they don’t even have, using their credit cards. The result? After a while
they don’t know how to pay back all the interests on these loans... How bizarre, wasn’t it
Thomas Jefferson –who partially designed the American declaration of independence– who
told us: “never spend your money before you have it.”?

Once interest rates began to rise and housing prices started to drop moderately in 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. Foreclosure is the legal and professional proceeding in which a mortgagee or a
lender obtains a court ordered termination of a mortgagor's equitable right of redemption.
Usually a lender obtains a security interest from a borrower who mortgages or pledges an
asset like a house to secure the loan. If the borrower defaults and the lender tries to repossess
the property, courts of equity can grant the owner the right of redemption if the borrower
repays the debt.12 Foreclosures accelerated in the US in late 2006. During 2007, nearly 1.3
million U.S. housing properties were subject to foreclosure activity, up 79% from 2006.13

But how did this cause a global financial crisis?

The house market downturn was a risk to the broader economy
because banks repacked these loans and mortgages in new
financial products, generally called derivatives. These were
bought by investors, investment banks, banks all over the world.
So, where banks traditionally lent money to homeowners for their
mortgage and retained the credit risk, now, banks can sell rights
to the mortgage payments and related credit risk to investors,
through a process called securitization (this due to financial
innovations discussed above). These are called mortgage backed
securities (MBO) and collateralized debt obligations (CDO).
Banks offered an increasing array of higher-risk loans. Even if
these high risk loans included the "No Income, No Job and no
Assets" loans, the “No, No, No...”in this sentence didn’t preserve
the lenders from taking these very high risks.

For example: you would like to buy the house of your dreams, but... you don’t have enough
money. You go to your bank to ask for a loan. By using easy initial terms, American banks
easily convinced customers to opt for this kind of housing-financement. The banks would

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collect several of these loans, repackage them and sell them to other banks, using these
derivatives.

This new banking model means
credit risk has been distributed
broadly to investors, with a series
of consequential impacts, so that
the main problem is that banks
were not aware of the risk they
were taking. The moment interest
rates began to rise and housing
prices started to drop moderately,
financing became difficult.
Defaults and foreclosure activity
increased dramatically. People
didn’t know how to pay back, went
bankrupt,... Banks didn’t really Changes in US housing Prices,S&P/Case-Shiller Indices 1988-2008; update
september 2008
know what to do and began to make
huge losses.

We have seen that mortgage-banks did “casino-banking” on a large-scale. Banks packed all
kinds of assets under untransparent packages that were sold worldwide to other banks,
investment funds and investors. Huge CDS and CDO markets were created. Banks made
enourmous benefits selling these products. Some dealers and traders made astronomic
benefits that you normally couldn’t get out of an economic activity.

Once the crisis seemed inevitable, we started
to ask ourselves if regulators were relying on a “There are more fools among
"free market philosophy" justifying their
‘just-let-things-go-strategy’?
buyers than sellers”
This old French proverb is based on a
All this risk-taking by banks and firms added simple imbalance of knowledge. The
up to a big gamble for the worldwide financial trading of money and goods may seem
system, which only became fully apparent as simple, but the seller of the goods usually
the crisis unfolded. Because no firm knew of knows pretty much all there is to know
other firms' exposures to complex and risk full about the object or asset he is parting with.
derivatives, it was difficult to predict how The buyer usually knows less.
problems would flow through the system.
The lack of transparency, that’s what it’s all Anyone who's ever sold a car or house
about. knows it's relatively easy to conceal a fault
from the average buyer. Even if money is
It’s clear that regulators didn't regulate. This of a known and certain worth, the risk to
counts as well for the Federal Reserve (U.S.) make a bad choice persists...
as for the revisors in mortgage-banks,
investment banks and other banks. Whether Those who sell profitable shares too soon,
they didn’t see the upcoming disaster, or only to see the price race away, can
wether they voluntarily looked the other way, certainly be called foolish. Yet there are
the regulators have always been largely probably fewer of them than those who
involved. bought a share just before a profit warning.

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As the crisis approached, few in government spotted these problems. In Belgium, for instance,
the government was busy trying to find a solution for the communautary problems, and they
didn’t have ear to the financial problems that seamed small and not dangerous.

We can conclude that the combination of negligence, lack of transparency and wrong
economic theory resulted in the current financial crisis. For years, the worldwide economic
system has been based on the illusion of "It doesn't matter." First there was the illusion of
"Deficits don't matter”. Later the illusion of "it doesn't matter" got extended to money
creation, megalomanias credit expansion, the stock-market bubble and the housing boom.

Then more problems appeared, first with some banks and than, after “the Lehman brothers-
effect”, with a lot of banks. The spread in inter-bank lending skyrocketed and only improved
after massive state intervention. The globalisation of the banking-system led to economic
weakness spreading around the globe. There is no new economic growth in sight. Yet many
investors stay put because they have been conditioned to believe that government will bail
them out, as we have seen with the nationalisation of Fannie and Freddie for the U.S and with
Fortis, KBC and Dexia for Belgium.

In the next chapter I will give an overview of the most important events.

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III. A time line of the most important events.
Hasty takeovers, government bailouts, bankruptcy filings, CEO ousters and lots of interest
rate cuts. 29 Together, they've provided plenty of controversy and second-guessing during the
year-long financial crisis. These are the most important events causing the current financial
crisis.

August 10, 2007: Fed Sounds Alarm

Amid growing financial market turbulence and cries for an interest rate cut, the Fed says it is
"providing liquidity to facilitate the orderly functioning of financial markets." A week later,
the Fed sayd "conditions have deteriorated" and it "is prepared to act as needed, but doesn't
cut rates.

Oct. 30, 2007: CEO Casualties Begin

Merrill Lynch Chairman and CEO Stanley O'Neal is forced
out, following major losses and write downs because of its
subprime business.

The disclosure of a massive loss linked directly to his strategy of taking more risk in the bond
markets, resulted in a write down of $8.4 billion of bad bonds and other securities, and caused
O'Neal to lose the confidence of the Merrill Lynch board, which he had largely composed
since he became CEO in 2002.

His successor, Kenneth D. Lewis (chief executive officer and president of Bank of America)
had the difficult task to avoid a civil war inside the company by selecting a candidate that
could bring the various warring factions together and help Merrill survive as an independent
firm.

His biggest mistake was to ramp up the firm’s risk taking. He raised Merrill’s exposure to
credit market risk instead of letting the firm grow through major acquisitions or organically.
Merrill began trading more in riskfull credit market instruments, like collateralized debt
obligations and he even bought a subprime mortgage lender at the height of the market.

When the markets for mortgage-backed securities plummeted, Merrill was among the hardest
hit—and, maybe the hardest hit of all the Wall Street firms. It initially announced a write
down of $5 billion due to losses from these bonds. But afterwards they wrote down a total of
$8.4 billion, and despite O’Neal’s claim that he used a conservative analysis to come up with
the write down, many analysts said the firm would likely have to announce additional losses
in the fourth quarter.

March 16, 2008: Bear Stearns Bought

The brokerage firm Bear Stearns is bought by JPMorgan Chase
in a $2-a-share deal engineered and backed up by the federal
government in the wake of big losses in the mortgage-backed
securities market and a shrivelling stock price. The price is later
adjusted to $10 a share, which hit a record high of about $171 in January 2007.

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The takeover underlined the risks banks and financial companies were facing as the U.S.
mortgage crisis deepend. Minutes after the deal was announced, the U.S. central bank made
an emergency interest rate cut and opened direct lending to Wall Street, but the moves failed
to soothe panicked investors. A bit later, the U.S. dollar fell to a new record low against the
Euro.

Bear Stearns had about $16 billion exposure to commercial
mortgage backed securities assets and $15 billion exposure to
prime, Alt-A mortgages (mortgages given to people with
relatively high credit scores who can't document their
income) and $2 billion exposure to subprime. The buyer,
JPMorgan, which in 2007 reported income of $15.4 billion,
had a relatively small prime brokerage business.

July 11, 2008: Indy Mac Bank Fails

Federal regulators seize the thrift amid concern about a run on deposits, as the combination of
the credit crunch and mortgage meltdown suffocates its business. The failure will cost the
Federal Deposit Insurance Fund an estimated $4-8 billion.

Sept. 7, 2008: Fannie, Freddie Seized

The federal government took control of Fannie Mae and Freddie
Mac, the two publicly-traded, government-sponsored financial
giants that held or guaranteed about half the nation's $12 trillion
in mortgage loans. This mortgage debt was sapping the
company’s vitality and threatened to undermine them at a time
other sources of housing finance had largely run dry. As already
mentioned in chapter two, as house prices, earnings and capital
continued to deteriorate, the ability of Fannie Mae and Freddie
Mac to fulfil their mission deteriorated. They had been unable to provide needed stability to
the market. Note that the buyout of two institutions, Fannie Mae and Freddie Mac was critical
to turning the corner on housing. Freddie Mac chief executive Richard Syron and Fannie
Mae's CEO, Daniel Mudd, were ousted and replaced by David Moffett, a former top official
at US Bancorp and Herb Allison, formerly with Merrill Lynch. In the next chapter, I will
comment a bit more the Fannie and Freddie case.

This was the biggest federal bailout ever, in a bid to support the U.S. housing market and
ward off more global financial market turbulence.

Sept. 10-15 2008: Lehman Brothers Flounders

The Wall Street firm Lehman Brothers puts itself up
for sale after reporting a $4 billion loss, but failed to
close a deal. Days later, with the federal government
having passed on a bailout, Lehman files for chapter

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11 bankruptcy protection, the biggest in history. 1 This event led to one of the largest
confidence crises in the financial sector in the last century: the failing of a large bank was
thought to be impossible, thought inspired by the salvage of Bear Stearns (cf. supra). This
event caused a massive increase in spreads on interbank lending.

Sept. 15, 2008: Merrill Lynch Bought

Merrill Lynch agrees to be bought by Bank of America in a $50-billion, all-stock transaction.
The acquisition makes Bank of America the largest brokerage in the world, with more than
20,000 advisers and $2.5 trillion in client assets. Merrill stuck with some of the same toxic
debt which torpedoed Lehman's balance sheet, has been hit hard by the credit crisis and has
written down more than $40 billion over the last year.

For some economists, it was a surprising step because earlier that month, Merrill Lynch
arranged to sell over $30 billion in repackaged debt securities to the Dallas-based private
equity firm Lone Star Funds. They seemed to improve their business and to progress.

The Bank of America bought about $44 billion of Merrill's common shares, as well as $6
billion of options, convertibles, and restricted stock units.

Sept. 16, 2008: AIG Bailed Out

The federal government provides an $85-billion emergency loan
package under which it takes a majority stake in American
International Group. The move comes amid a cash crunch, triggered
by $18 billion of losses over three quarters, a sinking stock price and
debt downgrades.

1
Chapter 11 is a chapter of the United States Bankruptcy Code, which permits reorganization under the bankruptcy laws of
the United States. Chapter 11 bankruptcy is available to any business, whether organized as a corporation or sole
proprietorship, and to individuals, although it is most prominently used by corporate entities.

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IV. Fannie and Freddie
3
Fannie and Freddie fuelled Wall Street's efforts to securitize subprime loans by becoming
the primary customer of all AAA-rated subprime-mortgage pools. In addition to this, they
held an enormous portfolio of mortgages themselves.

Over the years, Fannie and Freddie added up these mortgages to an enormous obligation. As
of 2008 June, Fannie alone guaranteed more than $388 billion in high-risk mortgages! This
created an environment within which even mortgage-backed securities assembled by others
could find home.

The mortgages in play were only low-risk investments if real
estate prices continued to rise, which they were supposed to do.
But, as the real estate market had already risen sharply over the
last years and trees don’t grow into the sky, real estate prices
started to fall. Given the excessive debt of many lenders and an
overleveraged credit market, the whole system came down like a
house of cards.

The two government-sponsored mortgage giants have long
maintained they were merely victims of a financial act they
didn’t control. As lots of other mortgage-banks, they were
blindsided by the greedy excesses of the subprime lenders who lacked scruples. But there is
no doubt that Fannie and Freddie are partially responsible for the mortgage-crisis. They have
played an important role in the financial crisis. In 2004, when the companies saw their market
share eroded by products as Adjustable Rate Mortgage (ARM’s) and interest-only mortgages,
they walked further out on the risk curve to maintain their market position. Out of their
reformed policies and management resulted that the two companies were responsible for some
$1,6 trillion worth of subprime credit!

The clear gravity of the situation pushed the legislation forward. Some might say the current
crisis couldn't be foreseen, though yet in 2005 Alan Greenspan told Congress how urgent it
was for it to act:” If Fannie and Freddie continue to grow, continue to have the low capital
that they have, continue to engage in the dynamic hedging of their portfolios, which they need
to do for interest rate risk aversion, they potentially create ever-growing potential systemic
risk down the road,'' he said. ``We are placing the total financial system of the future at a
substantial risk.''3

What happened next was extraordinary. For the first time in history, a serious Fannie and
Freddie reform bill was passed by the Senate Banking Committee. The GSE (government
sponsored enterprises)-bill gave the regulator power to crack down, and would have required
the companies to eliminate their investments in risky assets.

If that bill had become law, then the world today would be different. In 2005, 2006 and 2007,
“a blizzard of terrible mortgage paper fluttered out of the Fannie and Freddie clouds”, burying
many of our oldest and most venerable institutions. Without their check books keeping the
market liquid and buying up excess supply, the market would probably not have existed.

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The bill didn't become law because Democrats opposed it on a party-line vote in the
committee, signalling that this would be a partisan issue. Republicans couldn't even get the
Senate to vote on the matter.

With the necessary hindsight, the roadblock built by Senate Democrats in 2005 is
unforgivable. Many who opposed the bill doubtlessly did so for honourable reasons. Fannie
and Freddie provided mounds of materials defending their practices. Perhaps some found
their propaganda convincing.

But we now know that many of the senators who protected Fannie and Freddie, including
former senators Barack Obama and Hillary Clinton received mind-boggling levels of financial
support from them over the years.

Throughout his political career, Obama has gotten more than $125,000 in campaign
contributions from employees and political action committees of Fannie and Freddie.

Clinton, the 12th-ranked recipient of
Fannie and Freddie PAC and An Alt-A loan is nor really a loan type. Alt-A is a way
employee contributions, has received lenders have of grading or categorizing a loan. For
more than $75,000 from the two many lenders, Alt-A would be synonymous with A-
enterprises and their employees. minus. A-minus has traditionally been used to
designate borrowers whose credit scores are somewhat
So we must conclude that both Fannie below those of A grade borrowers. The traditional
and Freddie clearly understood that definition of Alt-A has been loans that have less than
these mortgages were risky. Though, full documentation, also referred to as low doc/no doc
many homeowners didn’t understand loans.
them, didn’t see the risk and many
corporations (mostly financials) were What does all of the mean to the borrower? It is
putting their business at risk by buying important for the borrower to understand that they and
up Alt-A and subprime mortgage- the loan they are applying for has a grade. The best
backed securities. place to be is A. A means the the borrower's credit
score is very good and the deal is straight forward
Also remember that during the period without anything out of the ordinary. A loans get the
when Fannie and Freddie increased most advantageous interest rates and terms.
their exposure to credit risk, their
regulator made no visible effort to Note that every lenders criteria for Alt-A/A-Minus
enforce any limits. As shown above, may be vary. Credit score requirements will be the
the two mortgage-giants tried to buy most common area of variance. It tends to boil down
everybody in town from both political to the risk tolerance of the lender.
parties, and the companies did it well
enough to make themselves immune Source: www.citytowninfo.com
from regulatory scrutiny.

Take a look at annex 2 to learn more about loans and mortgages.

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V. The current financial crisis’ nature
The current financial crisis is not of a
cyclical nature. The term economic cycle
refers to the fluctuations of economic
activity around a long-term growth trend.
It is a period of macroeconomic
expansion followed by a period of
contraction. The cycle involves shifts
over time between periods of relatively
rapid growth of output, and periods of
relative stagnation or decline. The
current financial turmoil is the symptom
of structural imbalances in the real
economy. Over decades, expansive
monetary policy has gone hand in hand with implicit and explicit bailout guarantees, and this
has fundamentally distorted the process of capital allocation.

The present financial crisis can also been seen as a confidence-crisis. Banks were taking huge
bets with each other over loans and assets. Complex products were designed to move risk and
disguise the sliding value of assets. Financial markets hinge on trust and that trust has been
eroded. The current financial crisis reflects that many debtors have reached their debt limit
and that creditors are lowering that limit. From now on, business and consumers,
governments and investors must work under the restraints of lowered debt ceilings. The
collapse of different banks marks a low in confidence. Financial companies have become
overextended and are now in need of deleveraging. America's financial system failed in its
responsibility to manage risk and to allocate capital. Regrettably, toxic mortgages and the
practices that led to them were exported to the rest of the world, especially Western Europe.

Economic policy as it is currently practiced is in a fix: lower interest rates may temporarily
help to alleviate the financial crisis, but they exacerbate the fundamentals that are the cause of
the financial crisis. Equally, a lower dollar would make imports costlier for the United States,
while a strong dollar comes with lower import prices. On the other hand, while a low dollar
would help to expand exports, a strong dollar impedes export growth.

Without an adaptation that would increase savings, decrease consumption, decrease credits
and reduce imports, the US economy can only go on in the old fashion with ever more debt
accumulation. Knowing that the US is at the origin of the crisis and that the US is still a world
player, we can expect Europe to follow. The financial crisis has reduced the willingness or
possibility of creditors to extend loans. It has become very difficult to get a loan. A profound
restructuring of global capital has become unavoidable. Such a process is quite different from
a recession in the traditional sense. Getting ouf of a traditional cyclical crisis can be done by
using macroeconomic instruments as fiscal and monetary policies. These fiscal and monetary
policies aren’t effective enough when it comes to re-establishing a balanced capital/financial
structure. Rebalancing the distorted financial structure requires stronger regulation and
important change in regulatory structures.

In chapter eight Iwill highlight some possible measures to get out of this crisis.

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VI. The great depression & lessons from the past

A big question is if we were able to foresee this crisis. During the past centuries the world has
been hit by different other financial crises. Was this crisis avoidable? In this chapter I will
give a small overview on the most important crises of the past. We will go through the
Barings-crisis of 1890, the great depression of the thirties (after the crash of 1929), the US
savings and loan scandal, the stock market crash of 1987, the Long Term Capital
Management downfall, to end up with the DOT.COM crash of 2000
28
OVEREND & GURNEY, 1866; BARINGS, 1890

The failure of Overend&Gurney, a London bank in 1866 led
to a key change in the role of central banks in managing
financial crises.

Overend&Gurney was a discount bank which provided
money for commercial and retail banks in London. When it
declared bankruptcy in May 1866, many smaller banks were
unable to get funding and went under. As a result, reformers
like Walter Bagehot advocated a new role for the Bank of
England as the "lender of last resort" to provide liquidity to the financial system during crises,
in order to prevent a bank failure or systemic failure.

This doctrine was next implemented in the Barings Crisis in 1890, when losses by the Barings
Bank - made on its investments in Argentina- were covered by the Bank of England to
prevent a systemic collapse of the UK banking system. Secret negotiations between Barings
and London financiers led to the creation of an £18m rescue fund in November 1890, before
the extent of Barings' losses became publicly known.

THE CRASH OF 1929

The Wall Street crash of 1929, also known as Black Thursday, was an event that sent both the
US and the global economy into a tailspin, contributing to the Great Depression of the 1930s.

After a huge speculation in the 1920s, based partly on the rise of new industries such as radio
broadcasting and car making, shares fell by 13% on Thursday, 24 October. Despite efforts by

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the stock market authorities to stabilise the market, stocks fell by another 11% the following
Tuesday, 29 October. By the time the market had reached bottom in 1932, 90% had been
wiped off the value of shares. Afterwards, it took 25 years before the Dow Jones Industrial
Average index recovered to its 1929 level.

The effect on the real economy was severe; the widespread share ownership meant that the
losses were felt by many middle-class consumers. These consumers cut their purchases of big
consumer goods such as cars and homes, while businesses postponed investment and closed
factories. This provoked an economic slow-down that engendered massive unemployment.

In 1933, Franklin D. Roosevelt launched The New Deal. The US central bank actually raised
interest rates to protect the value of the dollar and preserve the gold standard, while the US
government raised tariffs and ran a budget surplus. New Deal measures alleviated some of the
worst problems of the Depression, but the US economy did not fully recover until World War
II, when massive military spending eliminated unemployment and boosted growth.

The New Deal also introduced extensive regulation of financial markets and the banking
system through the creation of the Securities and Exchange Commission (SEC) and the
Federal Deposit Insurance Corporation (FDIC), and the separation of commercial and retail
banking through the Glass-Steagall Act.

Should we compare the current financial crisis with the crisis 1930? We now have the
monetary and fiscal instruments and understanding to avoid a collapse on that scale. The
crash of 1929 gave us organisations such as the SEC and the FDIC. One of the causes of this
financial crisis is massive speculation, a cause that we will also find back in the crisis of 1929.
We do also see that some consequences are similar: widespread share-ownership makes that
almost everyone is touched by the bank-crisis, consumers cut their important purchases,
industry goes down, investment decreases, factories are closed, unemployment increases. We
are following a similar down-ward spiral.

US SAVINGS AND LOAN SCANDAL, 1985

US Savings and Loans institutions were local banks that made home loans and took deposits
from retail investors, similar to building societies in the UK and the “spaarkassen” or “caisses
d’épargne” in Belgium. The 1980s were dominated by financial deregulation. In consequence,
banks were allowed to engage in more complex financial transactions.

By 1985, many of these institutions were all but bankrupt. The US government insured many
of the individual deposits in these institutions, and therefore had a big financial liability when
they collapsed. The government took over and sold any S&L assets it could, including
repossessed homes, taking over the bankrupt institutions.

The cost of the bail-out eventually totalled about $150bn. However, the crisis probably
strengthened the bigger banks by weeding out their weaker rivals, and laid the groundwork
for the wave of mergers and consolidations in the retail banking sector in the 1990s.

Could the knowledge ported by this crisis have had helped us avoiding the current crisis? Not
really, the current crisis is more complex. But we see that the 1980s already warned about the
consequences of a low degree of regulation.

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THE CRASH OF 1987

US stock markets suffered their largest one-day fall on 19 October 1987, when the Dow Jones
Industrial Average index dropped 22% followed by drops on the European and Japanese
markets.

The losses were triggered by the widespread belief that insider trading and company
takeovers on borrowed money were dominating the markets, while the US economy was
entering into an economic slowdown. There were also worries about the value of the US
dollar, which had been declining on international markets. Concerns that major banks might
go bust led the Fed and other major central banks to lower interest rates sharply.

"Circuit-breakers" were also introduced to limit program trading and allow the authorities to
suspend all trades for short periods. Circuit-breakers are measures instituted by exchanges to
stop trading temporarily when the market has fallen by a certain percentage in a specified
period. They are intended to prevent a market free fall by permitting buy and sell orders to
rebalance.

The crash seemed to have little direct economic effect and stock markets soon recovered; it
was a minor stock-market crash. But the lower interest rates, especially in the UK, may have
contributed to the housing market bubble of 1988-89 and to the pressures on the pound
sterling which led to the devaluation of 1992.

This crash already showed that global stock markets are closely linked, and changes in
economic policy in one country could affect markets around the world. Laws on insider
trading were tightened up in the US and UK and later on, other European countries also
instored laws on insider trading.

LONG-TERM CAPITAL MANAGEMENT, 1998

Long-Term Capital Management was the management arm of a hedge fund that operated from
its founding in 1993 until its liquidation in early 2000. It went through a period of spectacular
success from 1994 to early 1998. The belief was that in the long run, the interest rates on
different government bonds would converge, and the hedge fund traded on the small
differences in the rates.

The collapse of the hedge fund Long-Term Capital Market occurred during the final stage of
the world financial crisis that began in Asia in 1997 and spread to Russia and Brazil in 1998.
In August of 1998 Russia defaulted on its debt and the financial markets came unriddled.

LTCM, which had borrowed a lot of money from other companies, stood to lose billions of
dollars while investors fled from other government paper to the safe haven of US Treasury
bonds, and interest rate differences between bonds increased sharply. In order to liquidate its
positions it would have to sell Treasury bonds, plunging the US credit markets into turmoil
and forcing up interest rates.

The Fed decided that a rescue was needed. It called together the leading US banks, many of
whom had invested in LTCM, and persuaded them to put in $3.65bn to save the firm from
imminent collapse. The Fed itself made an emergency rate cut in October 1998 and markets
soon returned to stability. LTCM itself was liquidated in 2000.

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The LTCM failure highlighted the possibility that problems at one financial institution could
be transmitted to other institutions, and potentially poses risks to the financial system. This is
what we see today. Problems do not stay centerred, almost everyone is exposed to the risks
brought by massive lending, extreme hedging,... Although LTCM was a hedge fund, this issue
can not be limited to hedge funds. Other financial institutions, including banks and securities
firms are highly leveraged too.

While leverage can play a positive role in our financial system, problems can arise when
financial institutions go too far in extending credit to their customers and counterparties. The
failure of LTCM illustrated the need for all participants in our financial system to face
constraints on the amount of leverage they assume. It should have been a good lesson, but we
did not learn our lesson! Our financial system still relies on highly leveraged institutions.

In the case of LTCM, its investors, creditors, and counterparties did not provide an effective
check on its overall activities. This check on overall activities is important to guarantee the
system’s stability, but a high degree of leverage made it almost impossible to check on the
details of every activity. LTCM's use of leverage highlighted the lack of regulation in the
over-the-counter market. There is a need for more transparency and stronger regulation. Note
that the failure of LTCM does not necessarily mean that any use of leverage is bad, but it
highlights the potential negative consequences massive leverage can have.

LTCM failed to manage multiple aspects of risk internally. Managers mostly focused on
theoretical models and not enough on liquidity risk, gap risk, and stress-testing. With such
large positions, LTCM should have focused more on liquidity risk. LTCM's model's
underestimated the probability of a market crisis and potential for a flight to liquidity. The
LTCM-crisis further marks the importance of an effective Risk Management, because
exposure to specific risks can cause dramatic damage.

THE DOT.COM CRASH, 2000

During the late 1990s, stock markets became beguiled by the rise of internet companies such
as Amazon and AOL, which seemed to be ushering in a new era for the economy. Their
shares soared when they listed on the Nasdaq stock market.

The boom peaked when internet service provider AOL bought traditional media company
Time Warner for nearly $200bn in January 2000. But in March 2000, the bubble burst, and
the technology-weighted Nasdaq index fell by 78% by October 2002!

The crash had wide repercussions, with business investment falling and the US economy
slowing in the following year, a process exacerbated by the 9/11 attacks, which led to the
temporary closure of the financial markets. The Federal Reserve cut interest rates throughout
2001, gradually lowering rates from 6.25% to 1% to stimulate economic growth.

After having given this overview on the most important crises in the past, we remind some
key lessons:

Globalisation has increased the frequency and spread of financial crises, but not
necessarily their severity.
Early intervention by central banks is more effective in limiting their spread than later
moves.

17/31


It is difficult to tell during the first phases of the crisis, whether a financial crisis will
have broader economic consequences.
Regulators often cannot keep up with the pace of financial innovation: a permissive
policy by the financial authorities concerning complex financial products has frequently
led to acceleration or even creation of crises.
More transparency and better risk-management is needed.

Could we have anticipated this crisis?

As seen above, since 1980, we have had about five or six crises, the US Savings and Loans
Scandal, the crash of 1987 and the failure of Long-Term Capital Management in 1998, to
name only three. So the regulators and the markets have precedents from which they could
have learned. If we take in count the 5 key lessons defined above, we can conclude this crisis
could partially have been anticipated.

We have a certain idea of market fundamentalism, which is that markets are self-correcting. I
think that this is a false idea because it is generally the intervention of the authorities that
saves the markets when they get into trouble. As we’ve seen over the past few months, each
time, it is the authorities that bail out the market, or organize companies to do so.

Maybe this crisis could have been avoidded if people had understood what was wrong with
the current system. But finally, who could have recognized that?

The bankers? The authorities? The regulators? Well, the Federal Reserve and the Treasury
failed to see what was happening. Fed governor, Edward Gramlich, warned of a coming crisis
in subprime mortgages in his book published in 2007, but to no avail. It is clear that the
authorities did not want to see it coming. So it looks like as if it came as a surprise.

How much worse will it get? The situation is definitely much worse than is currently
recognized. You have had a general disruption of the financial markets, much more pervasive
than any we have had so far. This may not seem very optimistic, but in crisis times it is
pessimism that rules. During crises, we frequently forget Popper’s quote: “optimism is a
moral duty.”

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VII. The Impact on Emerging Countries.

Throughout this crisis that has consumed the attention of the world last year, we have watched
with grave concern as it cascaded outwards from the sectors originally affected, that are the
housing sector and the mortgage market. I think we can easily define this crisis by using Alan
Greenspan’s words: “a once-in-a-century credit tsunami”. Instability has surged from sector to
sector, first from housing into banking and other financial markets, and then on into all parts
of the world economy. The crisis has surged across the public-private boundary, as the hit to
private firms’ balance sheets has now imposed heavy new demands on the public sector’s
finances. A good example – as seen before- is Fannie and Freddie.
But this crisis has also surged across national borders within the developed world... That’s
one of the biggest reasons to fear that the crisis will swamp emerging markets and other
developing countries, cutting into their economic progress of recent years. 20

The investment-led boom in the developing world.

In the chart we can see the
bank’s exposure to emerging
markets (in %of the countries
GDP). This chart shows how
emerging markets depend on the
banks and the countries where
these banks are settled.
During the period from 2002 to
2007, developing economies
have been thriving. One
important set of reasons was
domestic. From a macro
economical view, we can say
that the developing economies
had entered the decade in much better shape than they had the previous two decades, for
example with lower inflation and more sustainable fiscal situations. These conditions
predisposed the developing world to more rapid growth. But because of the developed-
country boom, the developing world found its growth stoked further by increased export
revenues and higher commodity prices and a Global Foreign Direct Investment
(as % of GDP)
surge in foreign direct investment. We know 12%
that, during this period, economic growth 10%
increased export demand, so that developing 8%
country exports accelerated even beyond 6%
their rapid growth pace of the 1990’s. The 4%
increase of commodity prices resulted from
2%
and contributed to the growth in many
0%
developing countries. Exports increased as a
-2%
share of developing countries’ GDP from 29 1990 1992 1994 1996 1998 2000 2002 2004 2006

percent in 2000 to 39 percent in 2007. ource: IFS - IMF.
Another problem is that a severe and
prolonged recession could increase risk aversion, hurting investment flows to emerging
markets.

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The rapid increase in net private capital flows, direct and portfolio equity flows and
remittances of the country’s workers led to an investment boom in many developing
countries, led by the BRIC-countries (Brazil, Russia, India, and China). This in turn
stimulated their demand for capital goods from the US, Japan, and other developed
economies , further fuelling the growth of their economies. As a result the developing world
5

as a whole achieved its highest growth rates in decades.

This chart shows the evolution of the private
capital flow to emerging countries from
1997 to 2007. We can see the private capital
flow sharply declined after the dot-com
bubble of 2000. We can accept a much
larger dip in the current crisis, knowing that
the current crisis is one from another gauge.

A most important current feature of many
emerging markets is their ability to tighten
monetary policy -increase interest rates- in
the presence of inflationary pressures. This
contrasts with monetary policy in
industrialized countries where fears of a
significant slowdown in economic growth
are keeping interest rates low and
decreasing…in spite of expectations of higher inflation.
Czech Republic Chile China
8% 9% 9%
8% 8%
7%
7% 7%
6%
6%
6%
5% 5%
5%
4% 4%
4%
3%
3%
3% 2%
2% 2% 1%
1% 1% %
Jan-06 M ay-06 Oct-06 M ar-07 A ug-07 Jan-08 Jan-06 M ay-06 Oct-06 M ar-07 A ug-07 Jan-08 Jan-06 M ay-06 Oct-06 M ar-07 A ug-07 Jan-08
Inflatio n P o licy rate Inflatio n P o licy rate Inflatio n P o licy rate

Colombia South Africa South Korea
10% 12% 6%

9% 1%
1
10% 5%
8%
9%
7% 4%
8%
6% 7%
3%
6%
5%
5% 2%
4% 4%
3% 3% 1%
Jan-06 M ay-06 Oct-06 M ar-07 A ug-07 Jan-08 Jan-06 M ay-06 Oct-06 M ar-07 A ug-07 Jan-08 Jan-06 M ay-06 Oct-06 M ar-07 A ug-07 Jan-08
Inflatio n P o licy rate Inflatio n P o licy rate Inflatio n P o licy rate

20/31


Now, after that dynamism collapsed in developed countries, what will
be the effect on emerging markets and poorer countries?

Severe and protracted recession in the US / Banking crisis, high commodity prices and a high
inflation leading to increases in industrial countries’ interest rates are some factors that will
have a great influence on emerging countries. I think we are living the worst scenario: a
decline in the value of banks’ assets, loss of bank capital, credit crunch financing problems in
corporations and non-bank financial institutions, recession, increase in severity of bad banks’
assets, bank-bailouts...

Foreign direct investment tends to decline sharply during global slowdowns. Trade flows will
also be affected, especially because the US financial troubles expand to other industrial
countries, particularly Europe. Export growth suffers the most in periods of global
slowdowns.

The sustainability of high commodity prices is less risky in the short and medium-term due to
two factors that are of a cyclical nature or of a more structural nature. For the cyclical nature,
we can say that this is caused by an inverse correlation between the value of the dollar (and to
a lesser extent the euro) and the price of commodities. This is because commodities -
especially oil, gold and food- are perceived as a hedge against currency weakness and the risk
of inflation

Gold prices: Spots and Futures Aluminum prices: Spots and Futures
1200 3000

2800
1000 2600
USD per troy ounce

USD per metric ton

2400
800
2200

2000
600
1800
Futures Futures
400 1600

1400

200 1200
2002 2003 2004 2005 2006 2007 2008 2009 2010 2002 2003 2004 2005 2006 2007 2008 2009 2010
Source: IFS-IMF and NYMEX Source: IFS-IMF and LME

The structural factors concern the influence China has on the global system. E.g. the recent
policy signals by the Chinese authorities to control inflation point towards further increases in
interest rates in China and further appreciation of the RMB against the US dollar. We have to
take into account that China, a major importer of many commodities, will continue a strong
path of growth in the coming years. This will not be an inconspicuous movement. During
Januar and Februar 2009, Chinese GDP growth decreased, and so, China had to take measures
to keep it’s growth above the 8%. Note that this is the minimum-percentage to keep the
growth of employment high enough to support the migration to the cities.

Another good example of a structural factor is -as everyone knows- the supply problems in
the precious and industrial metals, which are a long-term issue, especially given South
Africa’s power crisis. Note that South Africa produces 69% of platinum, 30% of palladium
and 18% of world’s supply of gold. Other structural factors are land and water constraints

21/31


supporting high prices for agricultural commodities. On the following graphic, we can clearly
see that commodity prices almost crashed during the last months of 2008. This graphic shows
us the Reuters/Jefferies CRB Index; which is one of the most often cited indicators of overall
commodity prices. The CRB is representative of a broad range of commodity prices, that
offers investors a broad and reliable benchmark for the performance of the commodity sector.

Very low commodity prices, a decline in finance opportunities ... all affect the economy of the
exporting countries. The most important effect is a substantial reduction in their exports.
Remember that the IMF recently projected growth in world trade volumes of just 4.1
percent in 2009, down from 9.3 percent as 2006. On the 10th March of 2009, the head of the
International Monetary Fund, Dominique Strauss-Kahn, said the following: “ the world
economy is likely to shrink this year, in what some are referring to as the Great Recession.”

He also said that sharp declines in world trade were likely to hurt African economies. While
the fall in export volume growth is projected to be greater for advanced economies than for
developing economies, the latter may also suffer more from declines in the terms of trade –
especially in the case of commodity exporters.

The IMF expects that developing countries’ collective GDP growth will decline to less than 5
percent, compared with an average of more than 7 percent over the period 2004-07.
Moreover, the effects on developing countries may not be limited to a drop in investment and
export earnings and a slowdown of GDP growth. There is the danger that emerging markets
could go through crises of their own, for example if their own domestic asset-market bubbles

22/31


burst and weaken their own banking sectors. Sharp drops in stock markets in developing
countries have already warned us for this scenario’s possibility.

Developing countries will need advantages –as the strengthening of macroeconomic policies
including fiscal and external positions, the move to flexible exchange rate arrangement, a
drop in inflation and reduced commodity prices –to limit the damage from this crisis.

We conclude that developing countries are facing dilemmas whose solution will be highly
dependent on how they behaved during the boom period, as well as how the global shock will
affect their individual economies. Their ability to respond to the crisis will depend on whether
emerging markets have room to act in a “anticyclical” way by increasing domestic demand
without sacrificing excessively their fundamentals, such as the countries’ fiscal positions, debt
levels, domestic inflation rates, and the health of their domestic banking sector.

23/31


VIII. How to solve this problem?
Is there a stimulus key to recovery? We will not be able to solve all the problems by using
one single measure. A preliminary note is that no model of restructuring will be appropriate
for every country or every bank. Where solutions need to be customized this should be done
within a common strategy (on a regional or even worldwide scale) and framework that
ensures transparency and a “level playing field”. In the medium-term, the initiatives already
underway to improve the regulatory and supervisory frameworks will be crucial to build a
resilient and innovative financial system. So one must remember that there is no "one-size-
fits-all" policy mix because some countries have more fiscal and monetary space than others.
Considering this, it is welcome that some emerging economies now have more space for
policy easing than in previous crises and are making use of it. There are three domains in
which we have to invest in order to get the world back on track, these are:

1. The action already taken by many governments to stabilize financial markets and get credit
flowing again and/or fiscal stimulus through a combination of increased government spending
and tax cuts to revive consumer demand. A number of governments around the world have
already announced or accomplished stimulus plans, including in the United States, Japan,
Europe, China, and India. The importance of doing more on the spending side is that the
reaction of the economy to more spending is quicker than the reaction to a decrease in taxes.
But not only countries have to do an effort. Worldwide financing organizations are doing
extra efforts, the IMF, for example has already committed $47.9 billion in lending to a
number of economies affected by the crisis.

Monetary and fiscal policies need to become even more supportive of aggregate demand and
sustain this stance over the foreseeable future, while developing strategies to ensure long-term
fiscal sustainability. Moreover, international cooperation will be critical in designing and
implementing these policies in order to avoid destabilizing distortions.

2. Liquidity support for emerging market countries to reduce the adverse effects of the
widespread capital outflows triggered by the financial crisis. The continuation of the financial
crisis, with government policies failing to dispel uncertainty, has caused asset values to fall
sharply across advanced and emerging economies, decreasing household wealth, and thereby
putting downward pressure on consumer demand. We can expect real activity to contract by
around 1½ percent in the United States, 2 percent in the euro area, and 2½ percent in Japan.
Though more resilient than in previous global downturns, emerging and developing
economies will also suffer serious setbacks.

3. Help for low-income countries harmed by fallout from the crisis and the lingering impact of
last year's spike in food and fuel prices.

On the next page, you will see the latest IMF projections, an outlook on the changes in world
economy. The crisis in financial markets has resulted in a global recession that continues to
worsen. We see that the IMF prospects for global growth have markedly dimmed and
prospects on international trade have slowed sharply.

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25/31


To conclude, I emphasize two types of measures that are needed to turn things around:

1. Stronger policy actions to restore financial sector health.

Reviving the functioning of the financial sector and unclogging credit markets is a necessary
condition for economic recovery. The building blocks of what needs to be done have been
assembled to varying degrees in many countries, but a comprehensive framework for
restoring financial health and dealing with bad assets remains to be built. There is for instance
the idea of creating a Bad Bank. More aggressive and concerted actions are now needed—
through a unified approach involving liquidity provision, capital injections, and disposal of
problem assets.

2. Macroeconomic stimulus—both monetary and fiscal—to support demand.

On monetary policy, many central banks have taken strong actions to cut interest rates and
improve credit provision. Lowering interest rates, as inflation pressures are subsiding, is a
good measure. BUT: deflation is now a risk. In present circumstances, the effectiveness of
low interest rates to support activity is likely to be constrained as long as financial conditions
remain disrupted. Therefore, central banks will need to rely increasingly on unconventional
measures to unlock key (high-spread, low-liquidity) credit markets.

On fiscal policy, many countries have announced and are already implementing sizeable
stimulus. The key here is to design packages that provide maximum boost to demand, which
argues for measures to increase spending. However, fiscal deficits are widening sharply
because of the cyclical downturn and the impact of asset price declines on revenues, as well as
stimulus measures and the cost of financial sector rescues. Policymakers need to strengthen
fiscal frameworks and commit to credible longer-term policies that reverse the deficit build-
up as economies recover.

In summary, an approach to nurse financial markets back to health should deal with the
following topics:

• Central banks must provide ample liquidity to the financial system.

• Banks must be recapitalized to cover potential write downs.

• Problem assets on bank books must be dealt with in some manner.

• Speedy efforts to recapitalize banks and take care of distressed assets.

• A recognition that short-term policies must be consistent with the long-run
vision for the financial system.

• Transparency about policies, the use of public financial support, and decisions
about the future of any individual financial institution.

• A high level of international cooperation on national financial policies to
support institutions to prevent competitive distortions, regulatory arbitrage that
might harm other countries.

26/31


So the measures that have already partially been executed by some governments and central
banks need to be continued and –if necessary- stimulated. The only way to get out off this
crisis is by using effective financial policies that are comprehensive and internationally
coordinated.

Some of the measures that have already been accomplished, have stabilized financial
institutions, but there is always a certain risk that that they will distort credit allocation
decisions, crowd out markets that do not receive special treatment, disfavour more efficient
financial institutions that do not require public support. Moreover there are already concerns
about the fiscal implications of the government guarantees and recapitalizations. The costs are
likely to be higher than the amounts currently allocated, though much depends on the speed
with which confidence is restored. A comprehensive and coordinated approach needs to be set
up.

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IX. Executive Summary:
The first clear sign that the US housing bubble was bursting, the mid-2007 crisis in the sub-
prime mortgage market, transmitted losses to a whole set of securitized financial products
such as mortgage-backed securities. Many of these new securitized financial products with
layers of underlying assets were revealed to be far riskier than their credit ratings indicated.
The drop in value of these assets dealt a blow to the balance sheets of many financial
institutions. Even worse, the financial innovations of this decade – many of which had been
sold on the promise that they would diversify and minimize risk – turned out to be
transmission mechanisms for instability. The subprime mortgage crisis became a global
financial crisis, which in turn has led to a further collapse in equity markets.
Although the financial crisis struck first in the United States, the US is not alone in its
vulnerability to shocks and collapses in consumer confidence. Many countries, both
developed and emerging-market, have recently experienced bubbles in their asset markets.
Financial globalization makes this crisis more complex than other crises in the past. Financial
integration and cross-border holdings of mutual funds, hedge funds, developed-country bank
subsidiaries, and insurance companies have transmitted turbulence and helped propagate asset
price collapses in European and other countries. The bursting of a bubble this large, with the
financial consequences that we have seen in recent months for credit and equity markets
makes a recession inevitable in the US and likely in other developed economies. Indeed, job
losses and recession already occurred on a large scale.

28/31


X. Sources:
1. J.Korr, Explaining the Financial Crisis: Continuously Updated News Aggregation in
Action, September 17th, 2008.

2. M. Duffy, After the Financial Crisis, a Cleanup That Changes Everything, September
22nd, 2008.

3. K. Hassett How the Democrats Created the Financial Crisis, September 22, 2008,
www.bloomberg.com.

4. N. Roubini ,The Worst Financial Crisis Since the Great Depression is Getting Worse…and
the Need for Radical Policy Solutions to the Crisis, Mar 19, 2008.

5.A. Mueller, What's Behind the Financial Market Crisis, 9/18/2008.

6. S.Schifferes, Financial crises: Lessons from history ,BBC News, 2008

7. Joseph Stiglitz, The fruit of hypocrisy, The Guardian, September 16th 2008

8. The Financial Crisis: An Interview with George Soros, the new york review of
books.Volume 55, Number 8 · May 15, 2008.

9. Mandel, How to Get Growth Back on Track business week, October 16th, 2008, 5:00PM
EST.

10.The Financial Crisis Blame Game News Analysis October 18th, 2008, 12:01AM EST.

11. www-personal.umich.edu/~alandear/glossary/f.html, October 18th, 2008.

12. "The foreclosure fight is on", Douglas County News-Press (06-20-2008), November
12th,2008.

13. Block Colorado Foreclosure Blog, www.blockcoloradoforeclosure.com.

14. M.Bartiromo, "Jitters On The Home Front", Business Week. March 17th 2008.

15. Economist - When Fortune Frowned, October 9th,2008.

16. Blackburn - Subprime Crisis November 12th, 2008.

17. Hyman Minsky: Why Is The Economist Suddenly Popular? Dailyreckoning.co.uk.
October 10th 2008

18.F. Shostak "Does the Current Financial Crisis Vindicate the Economics of Hyman
Minsky? October 19th,2008

19. http://www.statefarm.com/bank/loans/mortgage/mort_products.asp

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20. Justin Yifu Lin, The Impact of the Financial Crisison Developing Countries,Korea
Development Institute, Seoul,October 31, 2008

21. Global Financial Stability Report, IMFth, , January 28th, 2009.

22. Http://www.imf.org/External/Pubs/FT/fmu/eng/2009/01/pdf/0109.pdf, January 29th

23. http://www.guardian.co.uk/business/gallery/2008/oct/28/marketturmoil-
creditcrunch?picture=339067974 charts

24. http://lippard.blogspot.com/2008/10/financial-crisis-via-charts-and-graphs.html

25. http://www.statefarm.com/bank/sr_cen, February 2nd, 2009

26. http://online.wsj.com/public/page/news-financial-markets-stock.html, Febrary 3rd, 2009

27. http://online.wsj.com/public/page/wall-street-in-crisis.htmlter/morgloss.asp, February 4th,
2009

28. www.cnbc.com/id/26755842, January 29th 2009

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