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Since the summer of 2007, people all over the world have became familiar with "subprime mortgage loans" - loans granted to borrowers whose credit history disqualifies them from conventional mortgage loans - which triggered the current global financial crisis and resulted in the worst global recession since the Great Depression of the 1930s. It is sometimes referred to as the Great Recession.
The Evolution of the Financial Crisis
The current crisis has had four distinct elements: 1) subprime mortgage crisis, 2) credit crunch, 3) global financial crisis, and 4) global economic crisis. This indicates the different phases marking the evolution of the crisis.
The first phase of the crisis began when New Century Financial, the second-largest subprime loan lender, filed for bankruptcy in March 2007. At the time, most people did not expect the crisis to last very long nor become very big. With the interest cut by US Federal Reserve, world capital markets showed resilience to the extent that in October 2007, the Dow Jones Industrial Average hit a record high of 14,164 points.
Slowly, however, the crisis began infiltrating various areas of the global financial system. Most financial institutions began to run low on cash and, although governments released massive amounts of money into the credit market, a credit crunch began to squeeze major financial institutions. As a result, investment banks either collapsed or were merged. Even Goldman Sachs, the largest investment bank, became a commercial bank. In March 2009, Citigroup, generally regarded as a symbol of capitalism, was essentially nationalized as the US government converted the preferred shares to common stock.
After the crisis began, eight instabilities appeared in global financial markets. The first was rising delinquency rates due to resets of adjustable rate subprime mortgages or ARMs, loans that started out at a low fixed rate but reset to higher, floating rates after 2-3 years. The resetting of ARMs peaked in the first quarter of 2008.
The second instability resulted from falling prices of mortgage -backed securities (MBS) and collateralized debt obligations (CDO) based on subprime mortgages. Outstanding issuance of CDOs in the US amounted US$1.9 trillion and CDOs at risk of turning bad are estimated at US$250 billion.
The third instability arose because of the liquidity crisis of structured...