Financial Risk Manager Part 1
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While the financial meltdown of 2007-2008 started in the US, it spread fast to other countries leading to worldwide economic turmoil. Which of the following statements best describes why the crisis spread so fast?
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TTanishq
A
Banks in the US had been the main financiers of a multitude of smaller foreign banks, and therefore when the financiers suffered liquidity problems, the smaller banks just couldn't obtain funding.
B
Global investors had overestimated the stability of emerging markets, which led to widespread panic and sell-offs when the U.S. financial crisis began.
C
The US entered into a recession, and their demand for exports fell, and therefore many countries experienced a major decline in exports, triggering a worldwide recession.
D
Foreign banks in Asia, Europe and other parts of the world had bought collateralized US debt and therefore when defaults rose, these banks lost a lot of money and consequently global lending, even among banks themselves, took a downward spiral.
Explanation:
Explanation
The global financial crisis of 2007-2008 spread rapidly worldwide primarily because:
Key Mechanism:
- Foreign banks in Asia, Europe and other regions had purchased substantial amounts of collateralized US debt (primarily mortgage-backed securities and CDOs)
- When US mortgage defaults rose dramatically, the value of these collateralized debt instruments plummeted
- This caused massive losses for international banks that held these assets
- Consequently, global lending froze as banks became risk-averse and faced solvency issues
Why Other Options Are Incorrect:
Choice A: While US banks did finance foreign banks, this was not the primary transmission mechanism. The crisis was fundamentally a solvency issue related to toxic assets, not just a liquidity problem.
Choice B: The crisis spread was not primarily due to emerging market instability concerns. The core issue was direct exposure to US housing market through complex financial instruments.
Choice C: While declining US demand for exports did contribute to the global recession, this was a secondary effect that occurred after the financial contagion had already spread through the banking system.
The correct transmission mechanism was the global interconnectedness of financial institutions through complex US mortgage-backed securities, which created a domino effect when the underlying mortgages defaulted.
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