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Introduction:

During 2007 the US GDP has slumped at 2%, but the Banks and economists were
unaware of the activities in sub-prime mortgage market and nobody thought this
might create a perfect financial storm in the country and widely influencing the
world economy in turn (Amadeo, 2017).

According to (Amadeo, 2017) When federal bank adopted low interest rates and
excess liquidity policy, due to increasing housing prices the investors turned towards
mortgage markets for higher return and neglected to assess the riskiness of the
investments and the probable bubble that may send the US financial market into
abyss in the long-run. Due to excess abundant liquidity coupled with incentive more
over mortgage markets has left no options for borrowers and banks never showed in
their balance sheet through securitization.

Initially the unregulated mortgage brokers extended loans to unqualified people in


United States. Due to higher mortgage rates and prices many homeowners preferred
to keep lesser monthly payments and opted for interest-only loans.

Due to its complexity no one properly understood the financial instrument, the
investors like financial institutions, hedge funds and pension funds bought high-risk
MBS were unaware of the risk factor involved while investing in MBS.

Thereafter when the housing prices started decreasing the homeowners couldn’t
afford to sell their home for a profit and they defaulted too along with the one who
earlier stopped making payments towards the housing loan. Later banks decided to
converted mortgages into another form and layered the mortgages based on their risk
appetite and rebranded them into mortgage-backed securities (MBS). The high-risk
MBS carried high interest rates and low risk paid lesser interest rates. Due to
complexity of mortgage financial instruments and lack of transparency even though

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the investors bought high-risk Collateralize Debt Securities with an intention of
making short-term profits. One by one the homeowners started to default the
payment and the demand for the house reached its lowest level. By this time federal
bank stepped into to restore the liquidity of banks and expected they would get back
to their normal business. The first hit was hedge funds incurred huge loss and by
March 2007 bad loans started accumulating and banks stopped lending to each other,
banks didn’t know how much bad MBS they have, and they were afraid to admit it
because of lowering of the credit worthiness by credit agencies. Banks anticipated
that their stock prices would start decreasing and further they may not be able to
raise funds from the market to survive. US Treasury Secretary Henry Paulson
lowered the interest rate to 2 percent and infused billions of dollars to restore the
liquidity into the banking system, but the situation even continued to worsen and
finally he realized banks had credibility problem instead liquidity problem. To
restore the banking system, Paulson created a super fund worth of $75 billion which
was guaranteed by the treasury and started buy bad mortgages. It was too late to
address the situation as panic engulfed entire financial market. The bankruptcy of
Bear Stearns clearly shows that they run business on shadow banking. Bear Stearns
could not able to convert its long-term assets into liquid cash and their short terms
financing was inadequate.

European Debt Crisis:

In early 2009 the euro zone entered a series of debt crisis it was all started with
Greece defaulted its sovereign debt and in the next three years Portugal, Italy, Spain
and Ireland suffered from severe sovereign defaults. The story of Ireland is almost
same as US financial crisis lending massive loans to the real estate and commercial
development was the main reason of Ireland’s financial crisis 2008. The leading Irish
Banks Allied Irish Bank, Bank of Ireland and Anglo-Irish Bank speed up the

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economic activity by given unprecedented loans to construction and real estate
industry. In Early 2008 the financial Institutions run a shadow banking system and
it can be described as a bank has assets which are termed as long-term and a short-
term liability in the form of deposits. Thus, banks face problems and they cannot
easily convert the long-term assets into ready cash when the depositors want to
withdraw their deposits. Another signal of crisis appears in interest rate spreads
(TED spread) it is a relationship between interest rate on three months U.S Treasury
bills and interest rate on interbank lending. The TED spread provides the extent of
counterparty risk from one bank to another. More the TED spread more the risk
concerns, the TED shot up from 40 bps to 240 bps between August 7, 2007 to August
20, 2007 ( Claessens, et al., n.d.).

One of the common reasons for the European debt crisis goes back to the
introduction of euro in 2001 because of which interest rates kept falling across the
European countries where prospects of increasing inflation earlier kept inflation
rates high. The investors in fixed income market believed that government bonds.
Until 2007 the European economy was relatively in a good position coupled with
low inflation and promising economic growth. Although the public debt was on the
higher side it is expected to be manageable. However, aftermath financial crisis in
US has changed everything in euro zone, early 2008 many European banks incurred
loss due to the exposure in US market. This caused fall in banks’ lending capacity
coupled with fall in house prices across European countries lead the euro zone to
serious recession. This resulted in increase of debt to GDP ratio and caused a sharp
decreasing in government public spending.

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Table:1
Gross Debt Percentage of
Country
GDP in 2010
Greece 144.9
Italy 118.4
Belgium 96.2
Portugal 93.3
Ireland 92.5
Germany 83.2
EU (27 Countries) 80.1
Source: Eurostat

Table:2
The General Government Gross-Debt Percentage of GDP (1996-2010)
Country 2007 2008 2009 2010 2010/07
Ireland 59 62.5 74.7 80.1 35.76
UK 44.4 54.8 69.6 79.9 79.95
Spain 36.2 40.1 53.8 61 68.51
Greece 107.4 113 129.3 144.9 34.92
Italy 103.1 105.8 115.5 118.4 14.84
EU (27 59 62.5 74.7 80.1 35.76
countries)
Source: Eurostat

From the table debt to GDP ratio of Ireland, Greece, Spain, Portugal are same when
compared to 2001, this contradicts that due to lower interest rates and introduction
of euro that made government to increase their borrowing. The table also infers that
Italy, Portugal, Hungary almost exceeded the Maastricht limit of 60 percent in 2007
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when US financial crisis started. It is to be noted that they shared slowest incremental
in debt to GDP ratio between 2007-2010. Hence these countries debt problem is
rooted before 2007 and didn’t worsen due to American financial crisis. The investors
thought there will be hardly default in euro zone and debt was safe due to support
among countries ensures low interest rates despite countries like Greece had a quite
high level of debt. The public debt in euro-zone is neither completely external nor
purely internal. The public debt issued by government in euro-area is denominated
in euro which is almost held by residents. Hence the issuing country cannot exert
full control over the euro in which the debt is issued. This characteristic makes debt
particularly in euro area both domestic and foreign as well. It should not be
misunderstood that public debt in euro-area with external debt. However, to get rid
of excess burden the government cannot return to high inflation as if the debt would
strictly domestic. According to the Lisbon treaty under article 125 it rules out the
likelihood of bailout of an EU member or by EU or by the other member state. Hence
in the absence of inflation regime and bailout options, if government wants to get
rid of excess debt it has only two options one is to adopt severe cost cutting measure
or default the debt payment.

European Debt Crisis- Individual Crisis

Ireland: During 2007 Major part of the revenue and economic growth of Ireland’s
economy was sourced by real estate and housing markets. Due to cheap funds
available in international market the Irish Banks fueled the real estate and
construction industry excessively, as a founder member of euro-zone the
government took advantage of fall in real and nominal interest rates and channelized
the funds to real estate and construction industry. The Irish financial crisis just
copied US sub-prime loan crisis. Early 2007 due to the dramatic changes in US
financial market, the prices of residential property started declining and continued

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in 2008. This resulted in the collapse of Irish Banking system. The root cause of
financial debacle in Ireland was the unmanageable and massive growth of real estate
and construction industry, adding fuel to the unprecedented economic development
the Irish banks routed large amount of money to real estate, property developer,
construction and speculative venture industry coupled with lesser interest rates, and
corporate taxes. The main reason behind Ireland’s financial crisis was massive loans
given to construction and real estate industry. The residential property prices posted
an exponential growth from € 57 billion to €157 billion during 2003-2008.
Alongside banks’ lending mortgages shots up from €44 billion to 128 billion in 2008.
This show that real-estate and construction industry had a big chunk of piece in
Ireland’s economic growth and nearly contributed 20% of the GDP of Ireland’s
economy (Storey, 2011).

Irish Banks heavily funded towards real-estate and construction industry and
neglected country’s core sectors like education, telecom, healthcare etc. even when
banks had lack of funds, raised international loans worth of €100 billion in 2007
towards pumping money to real-estate and construction industry.

During 1997 due to speculative nature investments in real-estate and residential


property were underestimated but the Irish common man always had a dreamt of
owning a house. Since real-estate industry operates on demand and supply. This
resulted in increasing of residential property loans approval from €4.4 billion to €13
billion during the period 1997-2006. To meet the demand for residential property
more than 430,000 houses were constructed during 2001-2007 and approximately
100,000 houses were constructed in 2006 when compared to demand of 380,00 units
houses in 1997. Due to shortage in the supply side the housing property inflated on
an average the house price saw an increase by 246% during 1997-2007, also the
rental price rose by 4602% in 2007. This euphoria made people to invest on real-

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estate and residential property. After observing an overwhelming growth in
residential property and real-estate the international agency IMF raised concerns on
over-pricing of this sector (O'Sullivan & Kennedy, 2010). The Irish Banks fueled
the real estate and construction industry excessively when residential and property
market crashed in 2008, the Irish government adopted remedial measures to tackle
the crisis. Later in 2013 European union announced a bail-out package of €85 billion
to restructure Ireland’s economy (Hess, 2015).

Cyprus: Failure of Banking System

Due to its low corporate taxes Cyprus is known as tax heaven and several
countries have their stakes in Cyprus Bank. The financial crisis 2008 merely
affected this small country. Cyprus has two well-known banks one is Bank of
Cyprus and other is the popular bank. Due to a strong historical and cultural
connection with Greece, financially Cyprus has invested nearly €5 billion in
Greek sovereign bonds this is approximately accounts for 20% of the Greek
bonds. Cyprus felt major economic and financial jolt when Greek had to face
severe government debt crisis in 2009. This resulted in borrowing €2.5 billion
from Russia to revamp its economy. After joining European Economic
Community (EEC) Cyprus was in stuck midway while realigning from
traditional monetary practices in-line with European standards. Another major
factor contributed to insolvency was sharp drop in real-estate and residential
property prices, this resulted in decrease of overseas investors. Further exposure
to Greek investment, increasing in non-performing asset (NPA) tightened
banking policies.in the mean time European Union rescued Cyprus with a quick
bail out of €10 billion to restructure its economy (Hess, 2015).

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Comparison of U.S and European Financial Crisis
According to (Weisbrot, 2014) There are a distinctive and striking differences
between the U.S financial and European financial crisis. Technically the US
crisis lasted for a year and half between December 2007-June 2009 and the
European debt crisis lasted about duration between January 2008 to April 2009
and later euro-zone recession continued up to third quarter of
2011approximately for two years. When the financial crisis broke down the
federal bank quickly addressed the problem with appropriate measures such as
reducing the treasury bills or the short-term interest rate to zero since then the
federal bank has maintained the same rate. This is followed by three rounds of
bond purchasing program to pump liquidity to the financial market to keep them
alive and reducing the long-term interest rates helped the economy to recovery
phase.

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Conclusion

Undoubtedly the causes of financial and economic crisis point towards the failure of
regulators and market participants. Understanding the reason for the financial and
economic crisis constructively all together might provide a guidance to revisit
legislative and regulatory reforms that strengthen the financial system and provide
an amplifying mechanism which intends to make financial markets more robust and
prevent the next financial disaster (Thoma, 2009). In response early signal of
economic downtrend, the federal bank would have taken corrective measures that
financial institutions weren’t exposed to unnecessary risk. But the regulatory
authorities adopted hands-off approach. This catastrophe could have been possibly
tackled by federal bank by necessary regulatory measures on private mortgage
brokers who mislead the financial institutions, hedge funds etc. The fed was unable
to identify the issue of credibility instead of liquidity and this led to shadow banking
and this gave an opportunity to sub-prime mortgage bubble. To some extent it was
due to financial innovation outperformed the human efforts. Even the market experts
who created the financial products were unable to understand potential impact of
MBS and other derivative instruments due to its complexity (Amadeo, 2017)

Bibliography
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Hess, K. C., 2015. Disparity in the Responses to the European Financial Crisis:, portland U.S: Portland
state university.

O'Sullivan, K. & Kennedy, T., 2010. What caused the Irish Banking Crisis?. ResearchGate.

Storey, A., 2011. Irishleftreview. [Online]


Available at: http://www.irishleftreview.org/2011/11/21/irelands-debt-crisis-roots-reactions/

Thoma, M., 2009. cbsnews. [Online]


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is-worse
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