**1. Introduction**

This chapter provides a contextual background to those that follow by describing the GFC and its salient characteristics, and identifying salient causes of the crisis. Once these salient causes have been identified, the thesis proceeds to investigate the extent of the role, if any, that economics and political mechanisms underlying securitization may have had in facilitating the GFC. Financial economists generally trace the beginnings of the GFC to approximately mid-2007, when a number of key mortgage lenders specialising in sub-prime housing loans experienced financial distress. For a number of reasons, banks and other mortgage originators had, in the years preceding the GFC, been able to lend home loans to lowto-mid-income borrowers<sup>1</sup> This practice, and the securitization arrangements based on it, would generally not have proved problematic if house prices throughout the United States had continued to appreciate as they had under speculative boom conditions. Problems arose, however, when the U.S. housing boom burst in 2006, and particularly in residential areas housing concentrations of 'sub-prime' borrowers.

<sup>1</sup> Often referred as subprime borrowers who, under normal lending criteria, would have been refused loans (eg. because of poor credit histories).

As investors became increasingly reluctant to invest in securities based on subprime housing mortgages, this financial distress spread to securitizers of a subprime mortgage loans, and was further exacerbated when credit rating agencies such as Standard & Poor's, Moody's, and Fitch downgraded many mortgage-backed securities. In the words of Allen and Carletti, the mortgage-backed sub-prime home loan securitization market 'simply broke down' [1] and a general loss of confidence became more widespread, affecting commercial asset-backed securitization markets in the latter half of 2007. Banks sponsoring many residential and commercial securitizers were required, under the terms of cross-guarantee arrangements, to pay debts that otherwise would have remained off-balance-sheet as contingent liabilities [2].

their traditional roles; speculative asset bubbles; and the U.S. sub-prime crisis and

This chapter looks into the main causes of the crisis, while developing a discussion on the contribution of each individual factor for the onset of the financial crisis. The chapter finds that GFC 2007 is a result of a number of factors. Some factors are linked with political decisions dated decades back in U.S political agenda, while some factors are market driven. The structure of the chapter is as fallows. Section 2 is a brief discussion on history of financial crisis in the modern world. Section 3, the main section of the chapter is a discussion on GFC 2007, with a special emphasis on housing bubble. This section glances over a number of contributory factors to the GFC including inter alia economical, financial, legal and behavioural factors that

Although examples of speculative bubbles are recorded in ancient times, in more recent times the most commonly cited early example of a speculative asset bubble is the Tulip Bubble in the 1600s. Tulips imported from East to Holland in the 1600s became a collector's item, and tulip bulbs were sold as very high prices. An influx of speculative funds was accompanied by a surge in financial innovation until the bubble burst in 1673, and many who had purchased bulbs on credit went bankrupt,

A second commonly cited speculative bubble in early modern financial history was the collapse of the South Sea Company, reported in England in 1720. The South Sea Company was a joint stock company, which was awarded a Royal Charter (monopoly rights) to trade in North and South America, and became the subject of massive speculation throughout Europe. The company's share price, recorded at £128 in January 1720, increased almost tenfold to £1000 over the next 6 months to July 1720. By the end of 1720 following a bursting of the bubble, however, it had

It was in early 1920s that the Florida real estate bubble burst. However the ability to purchase real estate with a down payment of 10% provided the leverage to the asset bubble. Accordingly house prices went up grabbing more peculators in to the business. The bubble burst in advance with a typhoon hitting Florida causing massive property damage. The sudden drop in prices paved the way for bankruptcies and default. The Great depression, the most longest, widespread, and deepest depression of the 20th century took place after the stock market crash of October 29, 1929. The speculative asset bubble started to grow in late 1920s' with the boom in many industries<sup>3</sup> resulting stock market speculation and paving way for thousands of investors to invest in the stock market, were as most of the investors have borrowed the money for investments. The asset bubble rose to such a high extent that the lenders have given loans up to three times of the face value of the stocks investors have purchased. Expecting stock prices to raise more, more and more funds were invested in the stock market creating a massive asset bubble by 1929. At the end with the dropping commodity prices the stock prices began to fall. By October 29, panic selling started and the stock market collapsed, leading to the

The 'Tronics' burst took place in 1961 with emergence of electronics in the market. A number of investors were keen on investing shares belonging to

the fallout resulting from it [6, 7].

*DOI: http://dx.doi.org/10.5772/intechopen.90728*

reverted to £124 per share [10].

longest depression in the world history [11–14].

<sup>3</sup> Steel production, building, automobiles etc.

**59**

may have contributed to the onset of the crisis.

*Political and Institutional Dynamics of the Global Financial Crisis*

**2. Speculative asset bubbles in modern financial history**

precipitating an economic depression all over the country [8, 9].

Institutional and corporate investors internationally had also purchased securitization products, adding to the linkages between large financial institutions in different jurisdictions. At about the same time, other banks in the United States, Britain and elsewhere in Europe—themselves uncertain about the extent to which they might be called to make unexpectedly large payments from their reserves under their own cross-guarantee arrangements with related securitizers and other companies—became reluctant to provide any more than very short term liquidity (of more than a few days' tenor) to each other. Institutional investors engaged in a 'flight to quality', investing in highly liquid, secure assets such as Treasury bills and other government securities. In approximately March 2008, company reports of further bad debts and asset write-downs because of mark-to-market accounting increased uncertainty about counterparty risk levels, with the result that global investment bank Bear Stearns Companies Inc. was unable to secure wholesale funding to continue its operations past mid-March, when it was sold to JP Morgan Chase & Co. for approximately 7% of its pre-crisis equity value [3].

Internationally, central banks in consultation with their governments intervened in their respective economies by markedly reducing official or cash rates; injecting liquidity into the system by effectively lending to primary dealers (e.g. by allowing them to swap less liquid asset-backed securities for Treasury securities, often at a substantial discount); and so-called government 'bailouts' of securitizing institutions perceived to be economically significant or 'too big to fail' (such as Northern Rock in Britain; and Bear Stearns, Fannie Mae and Freddie Mac in the U.S.) [4, 5].<sup>2</sup> In subsequent months, real economies in the United States, Britain and elsewhere in Europe have exhibited historically poor performance, with relatively high unemployment and low economic growth, despite relatively low interest rates and inflation.

Abstracting somewhat from this background, the GFC's chief characteristics as identified in the literature can be clustered around excessive system liquidity; high levels of executive compensation by community standards; high levels of financial innovation; banks and other financial intermediaries undertaking activities beyond

<sup>2</sup> A number of high-profile investment bank securitizers requested government support, including Bear Stearns, Merrill Lynch, Wachovia, Goldman Sachs, and Morgan Stanley. Of these, Bear Stearns, Merrill Lynch and Wachovia were ultimately sold at well below their year high equity prices, while Goldman Sachs and Morgan Stanley ultimately became commercial bank holding companies, subject to prudential regulation but able to access Federal Reserve swaps into liquid assets at substantially discounted prices. Another high-profile securitizer, Lehman Brothers, went into involuntary liquidation. American International Group (AIG), a global insurer and sub-insurer which had ultimately insured many of the securitization schemes affected by collapsing asset prices, was saved from liquidation by a U.S. Federal Reserve Bank 'rescue package' that enabled AIG to deliver additional collateral to its credit default swap trading partners

### *Political and Institutional Dynamics of the Global Financial Crisis DOI: http://dx.doi.org/10.5772/intechopen.90728*

As investors became increasingly reluctant to invest in securities based on subprime housing mortgages, this financial distress spread to securitizers of a subprime mortgage loans, and was further exacerbated when credit rating agencies such as Standard & Poor's, Moody's, and Fitch downgraded many mortgage-backed securities. In the words of Allen and Carletti, the mortgage-backed sub-prime home loan securitization market 'simply broke down' [1] and a general loss of confidence became more widespread, affecting commercial asset-backed securitization markets in the latter half of 2007. Banks sponsoring many residential and commercial securitizers were required, under the terms of cross-guarantee arrangements, to pay debts that otherwise would have remained off-balance-sheet as contingent

Institutional and corporate investors internationally had also purchased securitization products, adding to the linkages between large financial institutions in different jurisdictions. At about the same time, other banks in the United States, Britain and elsewhere in Europe—themselves uncertain about the extent to which they might be called to make unexpectedly large payments from their reserves under their own cross-guarantee arrangements with related securitizers and other companies—became reluctant to provide any more than very short term liquidity (of more than a few days' tenor) to each other. Institutional investors engaged in a 'flight to quality', investing in highly liquid, secure assets such as Treasury bills and other government securities. In approximately March 2008, company reports of further bad debts and asset write-downs because of mark-to-market accounting increased uncertainty about counterparty risk levels, with the result that global investment bank Bear Stearns Companies Inc. was unable to secure wholesale funding to continue its operations past mid-March, when it was sold to JP Morgan

Internationally, central banks in consultation with their governments intervened in their respective economies by markedly reducing official or cash rates; injecting liquidity into the system by effectively lending to primary dealers (e.g. by allowing them to swap less liquid asset-backed securities for Treasury securities, often at a substantial discount); and so-called government 'bailouts' of securitizing institutions perceived to be economically significant or 'too big to fail' (such as Northern Rock in Britain; and Bear Stearns, Fannie Mae and Freddie Mac in the U.S.) [4, 5].<sup>2</sup> In subsequent months, real economies in the United States, Britain and elsewhere in Europe have exhibited historically poor performance, with relatively high unemployment and low economic growth, despite relatively low interest rates and

Abstracting somewhat from this background, the GFC's chief characteristics as identified in the literature can be clustered around excessive system liquidity; high levels of executive compensation by community standards; high levels of financial innovation; banks and other financial intermediaries undertaking activities beyond

<sup>2</sup> A number of high-profile investment bank securitizers requested government support, including Bear Stearns, Merrill Lynch, Wachovia, Goldman Sachs, and Morgan Stanley. Of these, Bear Stearns, Merrill Lynch and Wachovia were ultimately sold at well below their year high equity prices, while Goldman Sachs and Morgan Stanley ultimately became commercial bank holding companies, subject to prudential regulation but able to access Federal Reserve swaps into liquid assets at substantially discounted prices. Another high-profile securitizer, Lehman Brothers, went into involuntary liquidation. American International Group (AIG), a global insurer and sub-insurer which had ultimately insured many of the securitization schemes affected by collapsing asset prices, was saved from liquidation by a U.S. Federal Reserve Bank 'rescue package' that enabled AIG to deliver additional collateral to its credit default swap

Chase & Co. for approximately 7% of its pre-crisis equity value [3].

liabilities [2].

*Financial Crises - A Selection of Readings*

inflation.

trading partners

**58**

their traditional roles; speculative asset bubbles; and the U.S. sub-prime crisis and the fallout resulting from it [6, 7].

This chapter looks into the main causes of the crisis, while developing a discussion on the contribution of each individual factor for the onset of the financial crisis. The chapter finds that GFC 2007 is a result of a number of factors. Some factors are linked with political decisions dated decades back in U.S political agenda, while some factors are market driven. The structure of the chapter is as fallows. Section 2 is a brief discussion on history of financial crisis in the modern world. Section 3, the main section of the chapter is a discussion on GFC 2007, with a special emphasis on housing bubble. This section glances over a number of contributory factors to the GFC including inter alia economical, financial, legal and behavioural factors that may have contributed to the onset of the crisis.
