World Economic Outlook, October 2008: Financial Stress, Downturns, and Recoveries (French Edition)

By the end of the year, Germany, Japan, and China were locked in recession, as were many smaller countries. Many in Europe paid the price for having dabbled in American real estate securities. Japan and China largely avoided that pitfall, but their export-oriented manufacturers suffered as recessions in their major markets—the U.

Less- developed countries likewise lost markets abroad, and their foreign investment, on which they had depended for growth capital, withered. With none of the biggest economies prospering, there was no obvious engine to pull the world out of its recession, and both government and private economists predicted a rough recovery.

How did a crisis in the American housing market threaten to drag down the entire global economy? It began with mortgage dealers who issued mortgages with terms unfavourable to borrowers, who were often families that did not qualify for ordinary home loans. Some included prepayment penalties that made it prohibitively expensive to refinance. These features were easy to miss for first-time home buyers, many of them unsophisticated in such matters, who were beguiled by the prospect that, no matter what their income or their ability to make a down payment, they could own a home.

Mortgage lenders did not merely hold the loans, content to receive a monthly check from the mortgage holder.

The Crisis Unfolds.

Frequently they sold these loans to a bank or to Fannie Mae or Freddie Mac, two government-chartered institutions created to buy up mortgages and provide mortgage lenders with more money to lend. Then the security would be sliced into perhaps 1, smaller pieces that would be sold to investors, often misidentified as low-risk investments.

What began as insurance, however, turned quickly into speculation as financial institutions bought or sold credit default swaps on assets that they did not own. As long as housing prices kept rising, everyone profited. Mortgage holders with inadequate sources of regular income could borrow against their rising home equity. The agencies that rank securities according to their safety which are paid by the issuers of those securities, not by the buyers generally rated mortgage-backed securities relatively safe—they were not.

When the housing bubble burst, more and more mortgage holders defaulted on their loans. By the mild slump in housing prices that had begun in had become a free fall in some places. What ensued was a crisis in confidence: The first major institution to go under was Countrywide Financial Corp. Bank of America agreed in January to terms for completing its purchase of the California-based Countrywide.

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The next victim, in March, was the Wall Street investment house Bear Stearns, which had a thick portfolio of mortgage-based securities. Bush—could find it necessary to insert itself into private enterprise, the rescue of Fannie Mae and Freddie Mac in September laid that uncertainty to rest. With the rush of defaults of subprime mortgages, Fannie and Freddie suffered the same losses as other mortgage companies, only worse. With Bear Stearns disposed of, the markets bid down share prices of Lehman Brothers and Merrill Lynch, two other investment banks with exposure to mortgage-backed securities.

Neither could withstand the heat. Lehman Brothers, however, could not find a buyer, and the government refused a Bear Stearns-style subsidy. In return, the U. Five days later saw the end for the big independent investment banks. Rather than proclaim their innocence all the way to bankruptcy court, the two investment banks chose to transform themselves into ordinary bank holding companies. Finally, in October, the Fed gave regulatory approval to the purchase of Wachovia Corp.

Other banks also foundered, including some of the largest.

There were competing theories on how so many pillars of finance in the U. One held the issuers of subprime mortgages ultimately responsible for the debacle. The firms that profited from this—from small mortgage companies to giant investment banks—deluded themselves that this could go on forever. Some claimed that deregulation played a major role.

In the late s, Congress demolished the barriers between commercial and investment banking, a change that encouraged risky investments with borrowed money. Deregulators scoffed at the notion that more federal regulation would have alleviated the crisis. Gramm and other opponents of regulation traced the troubles to the Community Reinvestment Act, an antiredlining law that directed Fannie Mae and Freddie Mac to make sure that the mortgages that they bought included some from poor neighbourhoods.

That, Gramm and his allies argued, was a license for mortgage companies to lend to unqualified borrowers. As alarming as the blizzard of buyouts, bailouts, and collapses might have been, it was not the most ominous consequence of the financial crisis. That occurred in the credit markets, where hundreds of billions of dollars a day are lent for periods as short as overnight by those who have the capital to those who need it.

The banks that did much of the lending concluded from the chaos taking place in September that no borrower could be trusted. As a result, lending all but froze. Without loans, businesses could not grow.

Without loans, some businesses could not even pay for day-to-day operations. Then came a development that underscored the enormity of the crisis. The Reserve Primary Fund, one of the U. Although money-market funds carry no federal deposit insurance , they are widely regarded as being just as safe as bank deposits, and they attract both large and small investors because they earn rates of return superior to those offered by the safest of all investments, U.

So it came as a jolt when Reserve Primary, which had gotten into trouble with its loans to Lehman Brothers, proclaimed that it would be unable to pay its investors any more than 97 cents on the dollar.

The announcement triggered a stampede out of money-market funds, with small investors joining big ones. Demand for Treasury securities was so great that the interest rate on a three-month Treasury bill was bid down practically to zero.

Bernanke was heard to remark that if someone did not do something fast, by the next week there might not be an economy to rescue. If government policy makers had taken any lesson from the Great Depression, it was that tight money, high taxes, and government spending restraint could aggravate the crisis. The Treasury and the Fed seemed to compete for the honour of biggest economic booster. So the Fed dusted off other ways of injecting money into the economy, through loans, loan guarantees, and purchases of government securities.

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Paulson initially intended to use the new authority to buy mortgage-based securities from the institutions that held them, thus freeing their balance sheets of toxic investments. This approach drew a torrent of criticism: How could anyone determine what the securities were worth if anything? Why bail out the large institutions but not the homeowners who were duped into taking out punitive mortgages?

How would the plan encourage banks to resume lending? The House of Representatives voted his plan down once before accepting a slightly revised version. The Treasury would instead invest most of the newly authorized bailout fund directly into the banks that held the toxic securities thus giving the government an ownership stake in private banks.

World Economic Outlook, October 2008 : Financial Stress, Downturns, and Recoveries

This, Paulson and others argued, would enable the banks to resume lending. An Assessment Chart Data 3. Chart Chart Data Data 6. Current Account Positions 2. Strains on Households Chart Data 2. Remaining Inflation Concerns Chart Data 2. Inflation Returns Chart Data 2. Are Credit Booms Cooling Off? Managing Inflation Pressures Chart Data 3. Results by Subregion Chart Data 6. World Economic Outlook Database October Have a WEO data question?

United States and Canada: Bending but Not Buckling Western Europe: Struggling with Multiple Shocks Advanced Asia: Responding to External Shocks Emerging Asia: Overheating Still A Concern References. Recent Commodity Market Developments Appendix 3.