THE past year was one to forget for investors, with the Dow Jones Industrial Average losing over a third of its value in the wake of a financial crisis that has swept the world and bankrupted many financial giants.

Experts believe that the crisis has its roots in the stock bubbles and macroeconomic policy of the 1990s. A soaring market meant investors were flush with cash, and a combination of a jump in productivity and increasing appetite for US debt meant inflation remained mild, allowing the Federal Reserve to keep interest rates low. At the same time Asian economies continued to grow, and more and more people entered global financial markets. The low benchmark interest rates and high demand meant debt yields remained low, and as a result investors looked for better returns in non-traditional markets.

Consequently credit continued to become both cheaper and easier to obtain, fuelling a consumption boom which was manifested in increasing home-sales. The US government also passed legislation to boost home ownership, making it more affordable for low income groups to afford a mortgage.

Home sales continued to surge, driving up prices and leading to the development of complicated financial instruments designed to reduce the risk of making home loans. One of these innovations was the mortgage-backed-security, which allowed investment banks to buy loans from commercial banks, and package them into lots whose performance was tracked by other bond-like instruments. Investment banks were then able to sell these bonds to a wide variety of investors, and as long as house prices continued to trend upwards, everyone continued to make money.

However, the financial innovation allowed commercial banks to make ever more risky loans (since they were no longer responsible for the principal or the interest to be paid off), which ended up in the hands of investors who did not fully understand them. Indeed this caused Federal Reserve Chairman Ben Bernanke to warn of ‘systematic risk’ in the mortgage market, and press Washington to pass legislation to head off a crisis as early as March 6th, according to Bloomberg.

The red-hot world economy sent energy and food prices rocketing upwards, further stretching the budgets of cash-strapped consumers, leading to a wave of late payments on their home-loans. News of this fed into the housing market, and house prices began to fluctuate. Mortgage-backed securities in portfolios around the world followed the trend, especially sub-prime debt, or loans made to people with poor credit, and the whole system began to wobble.

It was too late to be able to reverse the crisis by now, and barely a week after Bernanke’s warning, shares of the investment bank Bear Stearns went into a nosedive. Eventually the company was bought out by JP Morgan in a deal engineered by the Federal Reserve for a paltry $2 per share (later raised to $10 per share), after suffering losses based on sub-prime lending according to the Wall Street Journal.

However this was only the beginning of a long list of failures, with Lehman Brothers going under September 15th, and insurance giant AIG given an emergency $85 billion dollar loan by the Federal Reserve on September 19th. Washington Mutual collapsed on September 25th, while Wachovia followed suit on October 3rd. On November 24th, Citigroup announced it was receiving a further $20 billion dollar loan following a $20 billion loan in October, and that the Treasury and FDIC were to cover up to 90 per cent of the obligations of its $350 billion portfolio. The move came after the mammoth firm saw its share price plummet to record lows earlier in the week, Bloomberg reported.

It was not long before the fallout from the financial crisis began to affect the real economy; automakers for instance were hit hard as customers began to find it harder and harder to finance new car purchases. The three biggest US carmakers were thrown into such disarray by the credit crunch that they are now looking to the government for emergency loan packages to avoid bankruptcy, according Reuters.

Meanwhile in Pakistan, a floor was imposed on all stocks traded at the exchange on Aug 28th. This meant that share prices have been unable to fall below their values at the close of trading on Aug 27th, and therefore unable to price in the effects of the global slowdown.

The move came as the KSE-100 index lost over $36 billion from its peak in April, with no end in sight. Regulators believed that giving the market some time to ‘cool off’ would prevent panic selling and extreme volatility, according to Dawn reports.

However since the floor was put in place, Pakistan experienced record inflation, and a balance of payments crisis which necessitated an IMF bailout. At the same time US ratings agency Standard and Poors downgraded Pakistani government debt to ‘junk’ status. Political instability has also continued to grow, with the army locked in warfare against militants in NWFP and Baluchistan. Hence many believe that markets are poised to mirror or exceed the fall of the DJAs fall of over 25 per cent since Aug 28th, were the floor to be removed.