Introduction

In 2008, a series of bank and insurance company failures triggered a financial crisis that effectively halted global credit markets and required unprecedented government intervention.Fannie Mae (FNM) and Freddie Mac (FRE) were both taken over by the government. Lehman Brothers declared bankruptcy on September 14th after failing to find a buyer. Bank of America agreed to purchase Merrill Lynch (MER), and American International Group (AIG)was saved by an $85 billion capital injection by the federal government.
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Shortly after, on September 25th, J P Morgan Chase

[2]

(JPM) agreed to purchase the assets of Washington Mutual (WM) in what was the biggest bank failure in history. fact, by September 17, 2008, more public corporations had filed for bankruptcy in the U.S. than in all of 2007.
[3]

In

These

failures caused a crisis of confidence that made banks reluctant to lend money amongst themselves, or for that matter, to anyone. The crisis has its roots in real estate and the subprime lending crisis. Commercial and residential properties saw their values increase precipitously in a real estate boom that began in the 1990s and increased uninterrupted for nearly a decade. Increases in housing prices coincided with the investment and banking industry lowering lending standards to market mortgages to unqualified buyers allowing them to take out mortgages while at the same time government deregulation blended the lines between traditional investment banks and mortgage lenders. Real estate loans were spread throughout the financial system in the form of CDOs and other complex derivatives in order to disperse risk; however, when home values failed to rise and home owners failed to keep up with their payments, banks were forced to acknowledge huge write downs and write offs on these products. These write downs found several institutions at the brink of insolvency with many being forced to raise capital or go bankrupt. What is GFC?

The term financial crisis is applied broadly to a variety of situations in which some financial institutions or assets suddenly lose a large part of their value. In the 19th and early 20th centuries, many financial crises were associated with banking panics, and many recessions coincided with these panics. Other situations that are often called financial crises include stock market crashes and the bursting of other financial bubbles, currency crises, and sovereign defaults.
[1][2]

Financial crises directly result in a loss

of paper wealth; they do not directly result in changes in the real economy unless a recession or depression follows. Many economists have offered theories about how financial crises develop and how they could be prevented. There is little consensus, however, and financial crises are still a regular occurrence around the world.

Main causes of the Global Financial Crisis It is important to understand the main causes of the GFC the largest financial crisis since the Great Depression of the 1930s for a number of different reasons. First, the crisis was largely unforeseen by conventional neoclassical economists. Second, there are unresolved debates both among scholars and those on the political left about the causes of the crisis. Third, identifying the main causes could help us to understand why the crisis developed in the way that it did. Finally, knowledge of the causes could potentially be used to prevent such devastating effects in the future, particularly for the working classes and their dependents who are likely to bear the main brunt of the crisis and its economics. Lehmen brothers: Investment banking is extremely competitive. Lehman Brothers was the fourth largest American investment bank and aimed to become the biggest. In order to overtake its rivals, Lehman Brothers pursuit an annual growth in revenues of 15 %. In support of the revenue growth they targeted an even faster growth in total capital base, which was projected at 15 % per year. In order to achieve these expansion goals Lehmans management made major changes in its business strategy. They altered from a lower risk brokerage model to a higher risk, more capital intensive investment banking model. Instead of making money from transactions, they shifted towards making money on long-term investments. Lehmans management primarily focused on expanding three specific areas of principal investment: commercial real estate (real estate used for generating profit, like offices), leveraged loans (loans for leverage buyouts) and private equity. (Bankruptcy Report No.0813555, 2008) Lehman Brothers were also heavily involved in different kinds of subprime loans and mortgages. Subprime loans were loans to people which were considered financially risky, and were issued without or with little security. Because of the risk in these loans, they had higher interest rates. Subprime loans had become popular and widespread because of a long period of low interest rates in the wake of the September 11 attacks and the big housing bubble followed. There were also government initiatives that encouraged banks to issue loans so that even financially weak people could buy houses. (Norberg, 2009) Lehman Brothers, as well as the other leading investment banks, made big profits from subprime loans as long as credit defaults were at normal rates. The model was to originate loans and turn them into securities, which means splitting many

loans into tiny pieces and mixing them to even out the credit risk. The securities, called Residential Mortgage Backed Securities, were sold to investors to make money for the bank. Although the loans were considered risky, the securities were considered and rated to be almost as safe as state obligations. This was primarily because the loan takers were considered independent and due to ever rising real estate prices. When Monday came, September 15 2008, Lehman Brothers had to file for bankruptcy. An era of 158 years had ended; the largest bankruptcy in history was a fact, and what in the beginning was a credit crunch turned into a full blown financial chaos. Recession In economics, a recession is a business cycle contraction, a general slowdown in economic activity.[1][2] During recessions, many macroeconomic indicators vary in a similar way. Production, as measured by gross domestic product (GDP), employment, investment spending, capacity utilization rise. Recessions generally occur when there is a widespread drop in spending, often following an adverse supply shock or the bursting of an econo, household incomes, business profits, and inflation all fall, while bankruptcies and the unemployment ratemic bubble. Governments usually respond to recessions by adopting expansionary macroeconomic policies, such as increasing money supply, increasing government spending and decreasing taxation. Type of recession or shape Psychological aspects Recessions have psychological and confidence aspects. For example, if the expectation develops that economic activity will slow, firms may decide to reduce employment levels and save money rather than invest. Such expectations can create a self-reinforcing downward cycle, bringing about or worsening a recession.[9] Consumer confidence is one measure used to evaluate economic sentiment.[10]

Balance sheet recession The bursting of a real estate or financial asset price bubble can cause a recession. For example, economist Richard Koo wrote that Japan's "Great Recession" that began in 1990 was a "balance sheet recession." Liquidity trap A liquidity trap is a Keynesian theory that a situation can develop in which interest rates reach near zero (ZIRP) yet do not effectively stimulate the economy. In theory, near-zero interest rates should encourage firms and consumers to borrow and spend. Predictors Although there are no completely reliable predictors, the following are regarded to be possible predictors.[15] Inverted yield curve,[16] the model developed by economist Jonathan H. Wright, uses yields on 10-year and three-month Treasury securities as well as the Fed's overnight funds rate.[17] Another model developed by Federal Reserve Bank of New York economists uses only the 10year/three-month spread. It is, however, not a definite indicator;[18] Index of Leading (Economic) Indicators (includes some of the above indicators).[20] Lowering of asset prices, such as homes and financial assets, or high personal and corporate debt levels. [edit]Government responses

This section requires expansion.

Most mainstream economists believe that recessions are caused by inadequate aggregate demand in the economy, and favor the use of expansionary macroeconomic policy during recessions. Strategies favored for moving an economy out of a recession vary depending on which economic school the policymakers follow.

[edit]Stock market Some recessions have been anticipated by stock market declines. The real-estate market also usually weakens before a recession.[22] However real-estate declines can last much longer than recessions.[23] During an economic decline, high yield stocks such as fast moving consumer goods, pharmaceuticals, and tobacco tend to hold up better.Thus if the 2008 recession followed the average, the downturn in the stock market would have bottomed around November 2008. The actual US stock market bottom of the 2008 recession was in March 2009. [edit]Politics Generally an administration gets credit or blame for the state of economy during its time.[30] This has caused disagreements about when a recession actually started.[31] In an economic cycle, a downturn can be considered a consequence of an expansion reaching an unsustainable state, and is corrected by a brief decline. Thus it is not easy to isolate the causes of specific phases of the cycle. Effects of recession The global financial crisis is bound to have a major impact on developing countries, with the International Monetary Fund having downgraded its growth forecasts for 2009 by nearly two percentage points in recent months for both developed and developing countries. World growth is expected to be only 2.7% in 2009 (compared to 5% in 2007) and world trade is likely to stagnate. The World Bank is forecasting a drop in world trade in 2009.

There will be significant effects on international financial flows, with private financial

flows to developing countries expected to fall rapidly from record highs in 2007. Our latest research (Cali, Massa and te Velde, 2008b) 3 , based on current updates and forecasts as well as on evidence on what happened in previous slowdowns and in the absence of policy responses, suggests that net financial flows to developing countries may fall by as much as $300 billion over two years, equivalent to a 25% drop. The World Bank will be forecasting a drop of around $4-500 billion in two years. Some countries, including successful African countries, are more vulnerable than others (see Massa and Te Velde, 2008) 4 . The impact of the crisis on developing countries will affect different types of international resource flows: private capital flows such as Foreign Direct Investment (FDI), portfolio flows and international lending; official flows such as development finance institutions; and capital and current transfers such as official development assistance and remittances. The World Association of Investment Promotion Agencies foresees a 15% drop in

FDI 2009. FDI to Turkey has already fallen 40% over the last year and FDI to India dropped by 40% in the first six months of 2008. FDI to China was $6.6 billion in September 2008, 20% down from the monthly average in year 2008 so far, and mining investments in South Africa and Zambia have been put on hold. The crisis has led to a drop in bond and equity issuances and the sell-off of risky assets in developing countries. The average volume of bond issuances by developing countries was only $6 billion between July 2007 and March 2008, down from $ 15 billion over the same period in 2006. Between January and March 2008, equity issuance by developing countries stood at $5 billion, its lowest level in five years. As a result, World Bank research suggests some 91 International Public Offerings have been withdrawn or postponed in 2008. There is already financial contagion and stock markets have fallen around the world, with the largest losses since the 1930s. This has triggered etrenchment by investors, with reports that they have withdrawn $45 billion from Korea, $6.1 billion from South Africa, and $16 billion from India this year. Turnover on the nascent stock market in Uganda has fallen 60% this year. In the first eight months of 2008, remittances to Mexico (which depend almost exclusively on migrants to the USA) have decreased by 4.2%, with the strongest declines in August. Remittances to Kenya (which also depend on the US economy) have been hit even harder, with the Central Bank estimating a 38% year-to-year

drop in August. Effects of Recession on Investments and Companies

Effects of Recession on Banks

Excessive leverage (too much debt compared to equity) is the common culprit in all financial market crashes be it in 1929 (leverage by investment trusts) or 1987 and 1994 (leverage through collateralised debt and mortgage obligations and junk bonds)or 1998 (excessive leverage by LTCM and other hedge funds) or 2001 (leveraged bets on dotcoms) or 2008 (worldwide leveraged bets that US housing prices would not go down; and that interest rates wont fall). While banks traditionally have higher leverage than other businesses, countries where banks either avoided, or were barred from investing in difficult-to-value

derivatives, and consequently did not leverage excessively, have been left relatively unscathed. ICICI Bank's overseas operations has reported market to market losses of $264.34 million

CONCLUSION Global financial crisis of 2007-2008 had a complex set of causes. These were connected to underlying features of the US capitalist economy where the crisis began. A low rate of profit and large economic inequalities led to increasing capital flow into the financial sector and increasing recourse to credit by US workers whose real incomes were in decline from the early 1970s. New financial innovations, which developed in the wake of financial deregulation and floating ts. These could be sold on to other investors freeing up capital for more loans, generating fee income and passing risk down a chain of buyers. Risky financial products were given favourable credit ratings by credit ratings agencies whose own profits dependexchange rates, enabled debt to be parcelled into complex and opaque new financial produced on their inflated ratings. Credit default swaps seemed to provide extra insurance for mortgage-backed and other securities but heightened the risks to the financial system of a complete meltdown. The availability of free money, with cheap and apparently riskless lending enabled the rising leverage of investments; securitisation helped to spread the risks to global financial markets; and light or absent government regulation of finance cleared the way for these developments. A huge asset bubble developed in the housing sector which burst when interest rates rose and people began defaulting on their mortgages. As the value of housing assets fell, the institutions that held those assets were threatened with insolvency. A severe credit crunch developed when these institutions would no longer lend to each other.

Government policy : RBI Increases Repo Rate and Reverse Repo Rate to overcome Recession: In its Monetary and Credit Policy 2011-12, the Reserve Bank of India (RBI) has increased the repo and reverse repo rates by 50 basis points (bps) each, and announced a number of policy initiatives to fight inflation that continues to remain

stubbornly high. Before discussing the reasons behind this unexpected move most analysts were hoping for a 25 bps hike we first present a brief explanation of the monetary policy and then highlights from the latest RBI announcement. Cash Reserve Ratio (CRR): CRR refers to a portion of deposits (as cash) which banks have to keep with the RBI. CRR is intended to serve two purposes: one, to make a portion of bank deposits totally risk-free; and two, allow RBI to control liquidity, and consequently inflation. In cases when inflation is high, it can be controlled by withdrawing money from markets and this can be done by hiking CRR. When RBI wants to increase liquidity, CRR can be lowered so that banks have more funds at their disposal to lend.2. Statutory Liquidity Ratio (SLR): SLR is another quantitative control in the hands of RBI. SLR dictates the proportion of total deposits that banks are required to invest in government securities. Government securities (also known as giltedged securities or gilts) are bonds issued by the Central government to meet its revenue requirements. Although the bonds are long-term in nature, they are liquid as they can be traded in the secondary market. By fixing a proportion of

total deposits to be invested in government securities, RBI controls funds available with banks for other purposes, hence controlling liquidity. 3. Bank Rate: Bank rate is the minimum rate at which RBI provides loans to commercial banks. It is also called the discount rate. 4. Repo Rate: Repo rate is the rate which RBI charges for short term loans (of 15 days) secured by government securities. 5. Reverse Repo Rate: Reverse Repo Rate is the rate which RBI pays for shortterm funds of banks deposited with it. BIBLIOGRAPHY
Akyuz, Yilmaz (2008) The global financial crisis and developing countries, Resurgence, December, Penang: Third World Network. Augar, Philip (2006) The Greed Merchants: How the investment banks played the free market game, New York: Penguin Books. Chandrasekhar, C. P. (2008a) Global liquidity and financial flows to developing countries: new trends in emerging markets and their implications, G-24 Working Paper, available on http://www.networkideas.org/featart/jul2008/fa29_G24.htm Chandrasekar, C. P. (2008b) Indias sub-prime fears Economic and Political Weekly www.wikipedia.com