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Literature Review About The Current Financial Crisis

Since 2007, we are hearing everyone talking about financial crisis. During the past years, every day when we listened to the radio or watched the television, we would always hear about the global financial crisis, stock market crashes, subprime crisis, credit crunch and collapse of large and small companies in many parts of the world. In the context of this financial crisis, there are two simple questions that one would like to ask. “What has gone wrong on earth that caused today’s global Financial Crisis to happen?” and “What is the possible remedy?”.

No single cause or theory is fully sufficient in explaining the current financial crisis. Experts around the world have discovered many causes and have proposed various solutions to this problem. For example, academics blame defaulting mortgages, mispricing in the massive Credit Default Swaps Market, and so on to be the root cause of this crisis. Other authors also explain the financial crisis from the perspectives of the institutional theories. Experts are unable to reach a conclusion on how much importance to give each explanation of the crisis.

Professor Robert Shiller has argued that the current credit crunch (a reduction in the availability of credit or loan) is the result of the two recent bubbles in the stock market in the 1990s, and in the housing market between 2000 and 2007. He has used the term “irrational exuberance”, to describe the bubbles, and he claims that “this speculative enthusiasm of credit has pushed today's crisis”. According to the Professor, the current credit crunch has been caused by the psychology of the property bubble, and not by other factors, like for example the growing dishonesty among mortgage lenders. He also suggests some solutions to this problem. He points out that, bailouts are urgently required because: “People are suffering and businesses are collapsing. The memories of these traumas will harm confidence and trust in our markets for years to come, just as they did during the Great Depression. With each passing day more damage is done to our social fabric”.

The current financial crisis is seen as the worst crisis since the Great Depression, and has adversely affected the cost and availability of credit to businesses as well as households. USA is a market economy, and therefore credit is the lifeblood of the economy. The damage to the economy as a consequence of the constraints on the flow of credit has already been extensive. To be able to understand how the financial system of US broke down to such an extent, we firstly need to consider how global patterns of saving and investment have changed over the past decade, and how these changes have impacted on the credit markets in the US and other economies.

Normally, the basic functions of banks and other similar financial institutions is to accept deposits, that is, to take savings from savers, which can be businesses or households, and then mobilize the funds by providing loans. The loan can, for example help people to buy houses, or help businesses finance their raw materials. We must also note that financial markets, such as the stock markets, perform similar functions, as when a company raises funds for a new showroom by selling shares directly to shareholders.

We must note that, savings can also come from foreign sources. This is what happened in the US and other industrial countries, in the last 10 to 15 years, where these countries used to receive excess foreign saving. Foreign savings firstly came from oil-exporting countries. In these countries, there are rich investors but unfortunately, they cannot invest all their revenues profitably in their own country and had to invest abroad. Secondly, savings also came from some of the emerging markets countries. In 1995, net inflow of foreign saving in the US was recorded about 1-1/2 % of the US national output, and this jumped to 6 % in 2006, (about $825 billion).

Everyone knows that saving inflows are good to the country receiving them. However, excess savings can be harmful. When a bank has excess deposits, it has to give huge amount of interest to savers. To be able to do this the bank has to offer more loans, by attracting more borrowers. While trying to attract more borrowers, the bank can be forced to decrease interest rate of loans. Unfortunately, this is what occurred in the US and in some other nations. When financial institutions received surplus savings, a fierce competition for borrowers began to take place among the financial institutions. Consequently, credit such as loans became very cheap. One important result of this was a housing boom in the US which was encouraged mostly by a quick expansion of mortgage lending. These lending were done in an inferior manner, for example, it was found that in many cases, borrowers required little or no down payment. In intense cases, lenders became very careless and did not even make sure whether or not the borrowers will really be able to make their monthly payments. In fact, lenders believed that the price of house would continue to follow an upward trend which would allow borrowers to build up equity in their homes. Besides, the lenders also believed that credit would continue to remain frequently available and therefore borrowers could refinance if required. Many believe that during those times, regulators did not take appropriate actions to prevent this poor lending.

During the credit boom, return from financial assets such as Treasury Bonds, fell considerably due to the huge inflow of global savings into US. For instance, it is known that, emerging market countries like china invested their surplus foreign currencies in Collateralized Debt Obligations debts in the US and later these debts lost value and the countries have been severely affected. These issues put investors in a position where they were demanding alternatives investments, and to meet these demands, firms created securities that involved a combination of various individual loans which were difficult to understand by both the investors and the firms themselves that designed the securities. Later it was found that those securities contained substantial risks.

In early 2007, issues with subprime mortgages became so famous. Subprime Mortgages are defined as loan given to individuals with poor credit histories who do not qualify for conventional mortgages. At the same time, the price of houses started to fall. During those times, the credit boom started to unravel. Mortgage delinquencies were rising and price of houses were persistently following a downward trend which made the situation catastrophic. Investors started to face huge capital losses on their assets and as a result they moved away from the credit market. On the other hand, financial firms reduced their lending due to the fact that they were facing acute losses on mortgage.


In September 2008, the crisis worsened. This happened when many giant financial firms went into bankruptcy which caused credit and financial markets to freeze up. Firms that were severely hit by the crisis include Lehman Brothers, Washington Mutual, Merrill Lynch, AIG, Freddie Mac, Fannie Mae and Wachovia. Out of these, Lehman Brothers is believed to be the most intensely hit by the crisis which declared bankrupt in September 2008 and its bankruptcy is known as the largest bankruptcy in the history of US. Before its bankruptcy, Lehman Brothers was a very large firm that provided financial services across the world.

Stock Market Crashes

In October 2008, investors began to lose confidence and trust in the financial sector due to the failure or near-failure of many firms and this resulted in declining prices of stocks which lead to stock market crashes. Stock Market Crashes refers to a sharp and unanticipated decline in the stock prices which results in big loss of money by investors. The most intense decline was recorded on 6th October 2008 for Dow Jones where its industrial average fell by 18% in one week, (fell over 1,874 points). The week during which this event happened was known as the ‘Black Week’ which is a name given to particular times in the history that are believed to be unfortunate since a series of similar odd events occur. During the same week, S&P 500 experienced a decrease of more than 20%. Besides other stock markets were also affected during the same period, for example the Indonesian Stock market suspended trading on 8 October by experiencing a 10% drop on a single day. The stock market crashes created panic in most parts of the world.

During those times, destruction in the financial sector was evident, especially in the US. Since credit was no longer easy to obtain and given declining stock prices, a quick and profound contraction in the global financial and economic activities took place. Unemployment rate in many countries especially in US rose shaply and suddenly. We have to note that the contraction in economic activities continued through 2009 and 2010. The US is found to be the most severely hit country following the crisis. The financial crisis which emanated in the US also had a serious impact on other economies, especially those which were closely related to US, that is, countries that traded with US in the past. For instance, it is found that UK, France, Germany, and some other developed countries, went into recession just after the crisis.

Lehman Brothers

The financial systems of global firms are interrelated, especially, financial firms. When Lehman Brothers went into bankruptcy, many other firms and even foreign economies were heavily affected. It is known that the first reason for Lehman Brothers to go into liquidation was that the firm was highly geared in the years before the bankruptcy occurred. The gearing ratio was 31:1 by 2007 compared to 24:1 in 2003. A large fraction of this investment was in housing-related assets which made the firm exposed to the risk that prevailed in that market. Besides, the subprime lender of Lehman had to close down in 2007. The subprime mortgage crisis that happened in 2008 put Lehman into huge losses. Much of the losses came from lower-rated mortgage-backed securities. In the same year, the firm declared a loss of $2.8 billion and the firm also lost 73% of its stock value. In 9th September 2008, Dow Jones fell by 300 points and S&P 500 decreased by 3.4%, and this happened when the stock of Lehman lost about half of its value.

In 15 September 2008, Chapter 11 bankruptcy protection was filed by Lehman. The impact of Lehman’s bankruptcy was devastating. As a result of this bankruptcy, Dow Jones closed over 500 points on a single day on September 15, 2008. Due to the bankruptcy, the price of commercial real estate was expected to depress. Investors were also expected to sell their commercial real estate securities as Lehman was getting closer for the liquidation of its assets. Moreover, Lehman had been the broker and financer of several hedge funds. Following the collapse, the Hedge funds were being forced to decrease their financial leverage which provoked a fall of $737 billion in collateral outstanding in the securities lending market. In Japan, a loss of $2.4 billion of insurances and banks were declared following the Lehman’s bankruptcy. The Masaaki Shirakawa, the governor of Bank of Japan stated "Most lending to Lehman Brothers was made by major Japanese banks, and their possible losses seem to be within the levels that can be covered by their profits," adding “There is no concern that the latest events will threaten the stability of Japan's financial system.” Apart from these, the crash of Lehman Brothers was so profound that it had a strong impact on the politics of US also. The bankruptcy has been found to be one of the factors that influenced the 2008 US Presidential Election, where Barack Obama was elected as the new president of the United States.


There are various theories which attempt to explain financial crises. Some of the important theories on financial crisis include Marxist theories, Herding models and learning models Minsky's theory and the Coordination games.

Minsky's theory

Minsky's theory of financial crises, put forward by Hyman Minsky, originally attempted to explain financial crisis in a domestic context. However, we can relate this theory to the global context, which will help us understand the global economic crisis. The theories propose that there is a positive relation between fragility and risk of financial crisis. Financial fragility is one of the characteristics of the capitalist economy and is explained in the sense that, when the levels of debt increase, fragility increases. In simple terms, the theory explains that, when most of the firms of a country take considerable debts, this leads to an economic recession.

According to the Minsky’s theories, firms choose to finance themselves in three distinct ways, depending on the level of risk they wish to take. The first one is hedge finance, where income flows will be successful to service all debts including principal as well as interest. Secondly, Speculative finance is where income flow will be able to cater for only the interest payments. The third one and the riskiest, is the Ponzi finance which covers neither the interest nor the principal. In this case, the firm has no other choice apart from borrowing more or going for disposal of its assets simply to settle its debts.

According to this theory, firms become pessimist following a recession since they lost much financing, and they therefore choose only hedge finance which carries no risk. Later, when the economy climbs to growth, profits of the firms are expected to rise, firms become optimist and they go for speculative financing. Though they are aware of the fact that interest will not be fully covered all the time by the profits, they think that profits will increase and that they will be successful in repaying their loans without any problem. Lenders on the other hand, tend to lend without paying much attention about whether the firms will be successful in the future or not. This is because lenders believe that though the firms will have problems to repay its debts, it can refinance from elsewhere since their profits will be rising. This is known as the Ponzi financing where the economy has taken risk for much credit. Then, bankruptcies of some large firms begin to take place. This forces lenders to cut down their lending since they have become aware of the risk prevailing in the economy. In this case, more firms are crashed due to the fact that they are not able to refinance themselves. No money is injected in the economy to enable the refinancing process and it is then that the real economic crisis comes into existence. In the economic crisis, the firms again start to go for hedge financing and the cycle continues.

This theory reflects the crash of Lehman Brothers because it is known that one of the major reasons of this default was that the firm took much debts, in other words, it had a very high leverage ratio in the years before the default occurred. The crash of Lehman Brothers is also one of the potential drivers of the devastating effects of the current financial crisis.

Marxist theories

The financial crisis can be understood through another school of thought like the Marxist school of thought. To understand the Marxist theories on financial crisis, we need to assume a world which is comprised of a population of workers and well-run corporations. It is assumed that the workers work in these very corporations. The theories indicate that, though the profits of the companies are high, the workers are poorly remunerated in the sense that their wages are lower than the value of goods they produce. The profit will firstly mean to cover the capital invested in the business initially. However, in the long run, we find that, the population, that is, the workers have relatively less money to buy the goods since they receive less money (in form of wages). Many goods will remain unsold and this will result in abundance of goods, that is, an increased supply of goods which will force prices of the goods to fall. The fall in price will eventually result in fall in profit.

However, we must note that this theory depends on the percentage of the population who are workers (not businessmen or investors) and this also depends on the tax level on profits imposed by the government and returned to the population in terms of social benefits like health.

Herding models and Learning models

Herding models and learning models can also help explaining financial crises. To be able to understand the herding models, we need to understand the meaning of ‘herd behaviour’. Herd behaviour indicates how persons in a group are prone to act together without planned direction. In other words, a person tends to imitate the actions of other persons. In the finance context, when a group of investors are buying a particular asset, this encourages other investors to buy the same asset.

In these models, investors are assumed to be rational but do not have full information about the economy. If a few investors are buying let’s say asset A, then other investors will think that these few investors has got positive and full information about the asset A and they will also start believing that the true value of asset A is high. This encourages them to follow the same actions too by buying the shares of company A. However if the first investors were mistaken about the value of asset A, then this finally results in a crash.

Besides, herding behaviour is one of the most possible causes of stock market bubbles, which are situations, characterized by a rise or boom in the stock prices of a particular industry. A bubble take place when investors look at the rapid increase in value and decide to purchase by expecting further rises, rather than because the shares are undervalued. The stocks then become overvalued. In the Herding models, individual investors follow the actions of other groups of investors by entering or exiting the market when the other groups of investors are doing so. When the individual investors join the team of the other groups of investors, they will all persistently demand the same stocks at the same time which will lead to stock market bubbles and when they all want to sell their stocks at the same time, this leads bubble bursts where share price fall sharply, which leads to crashes. Many companies are affected and go into liquidation which eventually leads to financial or economic crises.

Another way of understanding financial crises is through "adaptive expectations" models or the "adaptive learning" models. Here investors are considered to be imperfectly rational. In these models, investors normally base their judgments on recent experience. For example, if the price of an asset follows an upward trend for some period of time, investors will start to believe that the price of the asset always follows this trend, that is, the price always rises. As a result this is going to increase the likelihood of the investors to buy the asset and this will cause the price of the asset to increase more and more. In the same way, if investors find that the price of a given asset declines for some period of time, this will finally result in the price of the asset to decline further and further. Thus, we can see that in these models, large changes in prices of asset can take place. Besides, Agent-based models of financial markets, most of the time, consider investors act on the foundation of adaptive learning.

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