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Journal number 1 ∘ Tsotne Gogishvili
The Nature, Formation, and End of 2007-2008 Global Financial Crisis

Expanded Summary

Financial crises are very familiar phenomena. However, 2007-2008 financial crisis unexpectedly hit US and Global financial market. The formation of the crisis did not start in 2007 but it was years in the making. The Depository Institutions Deregulation and Monetary Control Act of 1980 relaxed the rules under which national banks could merge. Moreover, the Gramm–Leach–Bliley Act (GLBA), also known as the Financial Services Modernization Act of 1999 allowed commercial banks, investment banks, securities firms, and insurance companies to consolidate. So concentration in the financial sector increased and the “too big to fail” mentality encouraged banks to engage in more risk taking activities. Thus, the Garn-St Germain Act allowed lenders to offer 2/28 adjustable-rate mortgages at low rates to attract subprime borrowers, but in the end when mortgage rates increased they could not afford the payments. Increased subprime mortgage lending since 2000 was one of the main reasons creating the housing market bubble. Before that banks only financed 80% (LTV=0.8) of the loan and interest rates were fixed. After 2000, subprime lending did not require much collateral from the borrowers, thus interest rates were fixed for a couple of years and after it was linked to LIBOR or other indices. Banks took high credit risk and provided an absurd funding like “Ninja” loans (no income, no job, and no asset) to the public. Their main purpose was to lend and make as much as possible in a short period.  They used well-established practice in the global debt capital market - securitization, which allows financial institutions to convert assets that are not easily marketable, such as mortgages or car loans, into rated securities that are tradable in the secondary market. The main reasons for banks to undertake securitization are to fund the assets it owns, balance sheet capital management, risk management, and credit risk transfer. Securitisation depends on the type of the underlying assets, often called mortgage-backed securities (MBS), or collateralized loan obligations (CLOs). Repackaging other securitizations is called collateralized debt obligations (CDOs, issuing bonds against a collateral pool consisting of ABS, MBS, or CLOs), collateralized mortgage obligations (CMOs), or collateralized bond obligations (CBOs). Financial institutions even used third-level securitizations, in which the collateral pool consists of CDO liabilities, which themselves consist of bonds backed by a collateral pool, called CDO-squareds. However, most of the investors did not understand the nature of the derivatives used and the real credit risk of loans used in the securitization process. Investors made decisions according to the ratings given by credit rating agencies but their methodologies were very optimistic and ratings undervalued credit risk of the securities.  In 2004, the FED rate increased to 5.25%, and people were unable to bear the expense of

higher monthly payments on mortgages.

Default rate increased and the housing market crashed in 2008. It effected not only US but the global market. Investors from all over the world invested in US mortgage sector but in the end they faced high liquidity problems which in most cases ended up with government involvement and bail out.  In the first quarter of 2009 GDP of Germany was -14.4%, Japan -15.2%, Great Britan -7.4%, and GDP declined in Eurozone by 9.8%. In case of Georgia, financial market is not highly developed and the impact was smaller. Moreover, Georgia was at war with Russia and funding after International Donors' Conference in Brussels, 22 October 2008 helped country to lessen the impact of the global recession.

We have listed some of the factors contributing to the global financial crisis but tha main one is greediness! Upper management, the traders and investors engaged in irresponsible risk taking and excessive trading to receive high returns, generous salaries and massive bonuses. Most regulators and risk managers igorned market, credit and liquidity risks placed in financial sector’s activities thus the majority of traders knew the risks they were taking.

After 2007-2008 financial crisis, most countries created legislation to enforce the Basel accords for their banks. The goal of the Basel accords is to incentivize banks to develop their risk measurement and management systems and to have higher level of safety and soundness in the banking system. Specifically, Basel III addresses the shortcomings of the banking system during the financial crisis and establishes many ratios (LCR, NSFR) to prevent liquidity problems and ensure adequate leverage for banks in the future. 

Key words: Global financial crisis, financial crisis of 2007-2008, global recession, securitization, liquidity crisis, subprime mortgage crisis.