October 17, 2008

Financial Crisis Sends World Reeling in Its Wake

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Over the last three months, Wall Street has taken America on a wild ride, dragging the world along with it. Setting records for the lowest drops and highest rises, the unstable market has left the economy in disarray and many are wondering what will come next. From an imploded housing market, to the collapse of multi-national corporations like Merrill Lynch, the effects are being felt across the globe.

While Wall Street has been left reeling in the wake of plunging stock indexes, what caused the recession? Many have traced the collapse of banks and the subsequent economic decline to the stagnant credit markets generated by subprime loans.
“With the credit crisis, what initially happened was that we had a period of 10 years with low interest rates — which meant that the economy had a lot of cash, and they started investing in housing. They took on subprime loans — loans to people with poor credit, poor jobs, or just generally high-risk homeowners,” said Kunle Olawoye grad.
The combination of low interest rates and over-eager banks resulted in people and corporations taking out loans with minimal requirements.
“After these loans were originated, banks packaged loan pools with some credit derivatives, and sold them out to Wall Street investors as mortgage-backed securities. These securities trade on Wall Street, and most banks hold a good amount on their balance sheets,” said Bahaa Naamani ’08. “When a large amount of subprime debt was defaulted, the mortgage-backed market for that debt collapsed. Banks that held this and similar debt on their balance sheet encountered major losses associated with these products.”
As a result, mortgage lenders who sold loans were left with trillions of dollars of bas assets, Olawoye explained.
Bad assets have forced banks to tighten down o­n lending, thereby freezing the credit market and exacerbating the recession.
Americans everywhere, from small business owners to homeowners to students, are feeling the pinch.
“The failure of the subprime market propagated the same fears to other debt investors which then started tightening their credit standards and raising credit prices, requesting higher interest … It, in fact, also affects the interest on student loans, car loans, etc., thus affecting every consumer in the U.S.,” Naamani said.

Global Effect
Markets around the globe are declining alongside the American economy, due to the interconnected nature of the global economy and a large number of foreign investors.
“We are seeing this grave effect take place because most developed countries have numerous ties to the American stock market, through foreign direct investment,” said Yousef El-Nazer ’10, currently abroad studying international business and finance at the American University of Cairo.
Olawoye, a Nigerian student, commented on the effects his home country is feeling from the decline.
“The Nigerian economy has plummeted over the last three months because foreign investors have pulled out,” Olawoye said.
The global sector will likely continue to suffer if the American markets do not begin to stabilize quickly.
“World economies today are more connected than ever before. The U.S. economic slow down has or will affect different countries by its impact on international trade, commodities prices, the countries’ financial systems and the exchange rates,” Naamani said.
One of the widest effects of the decline will be on the commodities market, which affects not only developed countries but impoverished third world countries as well.
“A lot of the merchant markets, primarily Latin American and African countries, have been driven by commodity prices like crude oil and steel. These prices have been dropping since August, so these countries are seeing less revenue from these natural resources,” Olawoye said. “For example, in Russia you will find that the slowdown of economic activity in the U.S. and Western Europe means that the demand for these commodities falls, then their prices and then the revenue.”
Naamani believes that while the commodity market will decline, it may not be as dramatic of an effect thanks to countries that will maintain a high rate of growth.
“In terms of commodities, the slowed demand in the U.S. will tend to soften commodity prices, but it is unlikely to break the bubble which has developed over the last few years because countries of high growth like China and India will continue to have very high demand on commodities,” he said. “If prices were actually to fall, commodity exporters of non oil commodities like Brazil and South Africa will suffer, while commodity importers — particularly India and China — will benefit.”
In the Asian markets, a drop in U.S. demand may not eliminate growth, but could severely tamper it.
“In a lot of Asian countries you have huge economic growth — about eight percent a year, and about 45 percent of that is facilitated by exports. A lot of the exports go to the U.S. or Western Europe, so when you have declined customer spending, you see a decline in that growth,” Olawoye said.
While the effects are undoubtedly negative for the majority of other nations the slowdown may be beneficial to some countries.
“The slowed economy in the U.S. will reduce the American demand for foreign products, thus hurting the export of many countries, like Canada, Mexico, Malaysia, Vietnam which are highly dependent on the U.S. in their international trade. But some, like China and India might actually welcome a reduction in U.S. demand — relief from their breakneck growth in a way,” Naamani said.
El-Nazer believes that while the U.S. may have a long road to recovery, foreign markets may be back much sooner.
“They’ll probably recover faster because these foreign countries have operations not only in America but several locations around the world. Some investments may just take longer than others to recover,” he said.

The Bailout
In an attempt to reverse the recession and stimulate the markets, the federal government has pledged a “bailout” plan of $700 billion. Though the bill was passed weeks ago the recent turmoil on Wall Street has left many questioning its functionality.
“The plan calls for the government to buy from firms up to $700 billion in troubled assets, whose values declined as the housing market imploded,” El-Nazer said. “The goal is to stabilize the companies and prompt them to lend again. The plan will certainly take some time to see results, but once implemented, there should be no reason for the plan not to succeed.”
Naamani believes that the bailout plan will effectively solve the crisis by relieving banks of bad assets, rather than simply throwing money at the problem.
“I think the bailout plan is strong — it’s like taking the bad apples out of the crate instead of adding more good apples to balance it out,” he said. “The federal government has already thrown hundreds of billions of dollars into strengthening the balance sheets of some banks by infusing capital in them. The bailout plan does something slightly different, which is to buy the bad products off the banks. The hope is that the markets will recalibrate themselves, and that things would go back to normal levels.”
Olawoye was also hopeful that the bailout plan will be a success, but stressed that the market’s current volatility makes it difficult to assess how long it will take.
“By mid-June next year everything will be settled if this bailout works out. Once credit markets start going again everything should settle, but we can’t be sure just because there are so many variables. The markets are irrational right now and we can’t really tell what will happen,” Olawoye said.