The subprime mortgage crisis in USA and Poland

7/30/2019 The subprime mortgage crisis in USA and Poland

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Abstract

The sub-prime mortgage crisis of the United States has grown into a global recession in a few years. As thefinancial markets themselves face the threat of total dysfunction, governments and policy makers across faced

a similarly hard decision: spend huge amounts of public money in hope of repairing the damage done or let themarkets "work it out" on their own. Keynesian economics started to bloom again, fiscal and monetary interventionscould be witnessed across the globe. In this paper we focus on three large key areas of interest while trying toanswer one important question: What can be learned of the recent years? While we try to answer that questionwe examine three larger topics. First of all, how the current financial and economic crisis started. What were themajor underlying causes of the financial breakdown? Was it avoidable or even preventable by the proper actionsof either economic actors? In the second part, we examine what path did the United States of America choose toavoid further troubles. How did the government and the Federal Reserve System acted during this critical period?What monetary and fiscal policy goals were followed and which ones were neglected for the sake of "keeping theeconomy running"? In the last part we turn our focus to a distinctively different country, Poland. As it is different byits size (both in terms of socio- geographical and economical terms), it similarly acted differently during the crisis.As the only country of the European Union which could produce economic growth during the hardest years, we tryto understand what made this performance possible.

Introduction

When I first had to face the problem of choosing a proper thesis topic in my sophomore

year all I knew it has to be something I am interested in. As semesters and months passed by, an

interesting topic rose, the sub-prime mortgage crisis of the United States. Of course I did not

know at that time what it really was, or how to properly call it but it surely made me wonder how

can savings of a lifetime disappear in mere days. As the internationally acclaimed American

sitcom South Park put it: "Poof... and it`s gone!"

As one of lucky participants of the Studies in Trans-Atlantic International Relations

program, I would have liked to have a thesis that embrace all three participating countries: the

United States of America, the Republic of Poland and the Republic of Hungary. During the

process of writing this thesis however it became clear, that not all countries can be examined in

proper depth due to the tangible and intangible constraints of a such paper. After careful

consideration I have decided to omit Hungary from current thesis. I felt, that as the source of the

sub-prime mortgage crisis, the United States cannot be the one left out if one wants to understandhow it all began. As to picking Poland against Hungary I have very simple reasons. Influencedby

my studies at the Cracow University of Economics (Uniwersytet Ekonomiczny w Krakowie),and


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spurred by the excellent economic performance Poland has shown in recent years I decided notto

wade into the frail topic of Hungary, leaving it for another time, maybe another paper. Most of

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the research of this paper was concluded in 2010 and 2011, and as such most recent

developments are not reflected in it.

I found the coincidence interesting, that both nations hold the eagle in high places. Both

coat of arms represent an eagle: the bald in the case of the United States and the white in the case

of Poland. It is known, that eagles have an unique way of escaping the storm. When it is coming,

they simply use its winds to soar above the dark clouds. I found that the picture can be broadened

in my thesis, examining how these two eagles fared in the storm.

This paper consists of three main parts. The first part tries to shed some light on the roots

of the financial crisis, based on evidence mainly presented in the report of the Financial Crisis

Inquiry Commission. Created under President Barack Obama, the commission was given the task

"to examine the causes, domestic and global, of the current financial and economic crisis in the

United States" under section 5 of the Fraud Enforcement and Recovery Act of 2009. As we tried

to draw our sources from the widest range possible, they spread from data gathered from official

sources, such as different U.S. Departments, International Monetary Fund, World Bank, through

testimonies made before the House and the Senate to private interviews and other scholarly

sources. We did not aim to fully explore to what extent the different actors could be held

accountable for the crisis itself, as we did not find compelling evidence that either the

government or any other single actor could be pointed as the sole one responsible for the crisis.

As the crisis and the global recession is a still ongoing process, there is much debate andeven more differing opinions on the haws and whys. But as time passes by, there is also more

ground for common agreements. The causes behind the sub-prime mortgage crisis is one such

topic, where there are common conceptions and ideas, while different views also exists, e.g. on

the relative weights of the different factors. In our thesis, we identified nine major, more or less

distinct causes for said economic turmoil. In the first major part of current paper, we examine

them more closely, but for the sake of clarity let them stand here with a short summary of each.

For several different reasons, from which the role of the Federal Reserve System is only

one, the size and amount of liquidity and borrowing grow enormously in the United States. As

several large countries such as China, Brazil or other oil-exporting countries managed to amass

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large surpluses, international borrowing boomed. The target areas were in the West, focusing

mostly on the United States and Western Europe. Paired up with emphasized housing policies in

said countries, several housing bubbles evolved, not only in the U.S. but in other countries as

well. New financial products appeared in the market in bigger numbers, securitization of second

rate or sub-prime mortgages took to heights never seen before. Credit rating agencies failed to

cope up with the complexness of these new products, their ratings were often overoptimistic,

producing higher than real prices for those securities.

As these financial assets became more and more complex, investors and agencies alike

relied heavily on those ratings. When the mortgages started to default, both the housing andcredit

bubbles burst. Prices of mortgage backed securities plummeted, trading stopped. Credit ratings

were changed overnight, tranches rated AAA became worthless in hours. The effects rippledthrough the whole financial system, damaging nationwide investor groups, international banking

systems and consumers alike. The very institutions which were created to foster homeownership

and safe investments turned on their creators, the government backed enterprises as Freddie Mac

and Fannie Mae reported huge losses. Bank runs started, as consumers started to panic that they

will not get their investments and savings back. Interbank lending came to a halt, causing severe

liquidity issues across the system. Institutions using overnight repo market actions found their

sources dried up.

As the major figures of the financial system called out for help, industry giants as

Citigroup or American International Group proved that the problems cannot be isolated, the

whole system was contaminated through the sub-prime mortgages. While the first actions taken

were aimed at stabilizing the financial system and its actors, it also became clear that the effects

will not stay in the financial sector, the ripples spread throughout the whole economy.

Unemployment started to rose, public spending took a jump, fiscal and monetary policy were

both loosened.

The second major part examines what were the responses deemed proper by policy

makers to this financial meltdown. As we tried to separate actions initiated or carried out by

either the government or the Federal Reserve System, we had to realize that the borderline

between these two is often blurred. While we can track the main courses of fiscal and monetary

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policies, there was also room for joint efforts. As we will see, several large scale programs were

started by different U.S. Government Departments, but the funding or financial background was

often linked to the Federal Reserve System. It is unclear whether policymakers can be allowed to

clear the debris at all. Many argue that the current situation is a direct result of irresponsible

fiscal

and monetary policy, where long term goals and needs were deemed only secondary behind

elections and political reasons (Gyrffy, 2009, p.333).

As different problems rose the answers had to be different as well. While using the

common tools one can - such as setting targets for fund rates and clear communication of those

targets - the Federal Reserve System developed new tools to face the rising challenges. As large

financial institutions found it harder and harder to provide sufficient liquidity, the Federal

Reserve allowed them to turn to its discount window for borrowing purposes. As the crisis wenton, the base of which institutions can access its help was broadened, to minimize the chance of

said institutions going bankrupt. As it turned out, saving only one of those firms would havebeen

more expensive compared to the cost of opening up lending sources.

As the cause behind the liquidity issues could not be solved solely by expanding

borrowing, the Federal Reserve launched several programs to increase stability, and foster

lending. With correct information about credit risks and asset prices deteriorated, the Federal

Reserve decided to provide liquidity directly to borrowers and investors. This was the first step

where not the nationwide institutions were being focused but small scale, private investors and

consumers.

The Federal Reserve also decided to promote lending and improve the state of the

mortgage backed securities market by announcing and buying large shares of such securitiesfrom

the asset pool of the government backed enterprises. These steps were highly effective, as their

result cost of lending declined and the borrowing rates normalized. Interbank lending resumed,confidence slowly returned to the market.

The financial crisis could not leave the governments without response. As the political

power was passed from republican to democrat hands, the acts of the previous governments are

often viewed with more than critical eyes. While the first economy stimulating programs were

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often deemed insufficient or flawed from the core, the government led by President Barack

Obama followed the steps of its predecessor. Similar programs were started and carried out,

irrelevant to the views on economic policies of their initiators. The first large scale program was

aimed to lessen the stress and promote stability in the early months of the turmoil. The Economic

Stimulus Act was signed into law by President George W. Bush. Through its efforts consumer

spending was hoped to increased through refundable credit. Data gathered after the launch of

such programs are often controversial. According to public polls most of these rebates werespent

on either saving or repaying debts, while consumer spending indeed grew in the period shortly

after the rebate checks were issued. As unemployment rose, the benefits related tounemployment

were extended as well, in many cases even doubled both in terms of financial help and eligibility

period. Medium and small scale businesses received incentives to promote their stability, and to

lessen the chance of more employers going bankrupt.

The second large scale program was initiated only half a year later, with the Emergency

Economic Stabilization Act, signed into law in October, 2008. As the first such law was focusing

on individuals and small size institutions, EESA put heavy emphasize on nationwide and large

scale systems. It had a broad scope of interest, ranging from stabilizing the financial system and

its institutions, to public housing and the auto industry. The government provided assistance and

capital to those institutions in need. With the confidence in the financial markets plummeting,

lending came to a halt. To ease this burden, the U.S. Treasury agreed to absorb unforeseen losses

on certain assets, thus restoring faith in the market.

One of the major problems during the crisis was that, as trading in mortgage backed

securities stopped, their market price could not be explored. To solve this problem, the Treasury

announced it will buy mortgage backed commercial and non-agency residential securities. With

accessing credit becoming harder and near impossible, the government tried to jumpstart the

system by purchasing securities worth millions of dollar. The automotive industry alwaysgenerated patriotic feelings, and when the winds of the storm reached it, the call for help could

not go unheeded. Emergency loans were provided to several nationwide industry giants, to

prevent their downfall. When the housing bubble bursted, families found them in dire situations,

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unable to cope up with their rising debts. Several actions were taken to help such individuals, by

making permanent changes to their mortgages or preventing foreclosure.

As more and more of money were spent on helping out the economy, the voices calling

out for a stop for such practices became louder and louder. The Wall Street Reform and

Consumer Protection Act was created as a response to these voices. Using taxpayer money tobail

out institutions, even those deemed "too big to fail" is not out of the question. The foul practiceof

golden parachutes is also being removed, whether it was successful or not is yet to be seen.

However absurd it may seem, as many thought the credit rating agencies were responsible for the

situation, an agency was created to evaluate and rate those agencies. By creating a new office

responsible for financial consumer protection, someone has the power to intervene when it is

necessary, without entering the mazes of bureaucracy.

The efforts made to avoid a system meltdown were costly. Billions of taxpayer money

were spent, and the recession is not over yet. But it is also clear that without any help, the

damages would far outdo what we have now. While it is important that many managed to keep

their jobs and homes due to the different actions taken by government and other actors, what is

more important that the financial system is back and running again. It is not necessarily in a

better shape than it was before the autumn of 2007, but it surely looks healthier since then. It

seems that the loosening of fiscal and monetary policy goals were the right action to do. As

government debt rose to even higher levels due to the massive spending, the question for the next

years is how to return to the pre-crisis levels. A good sign of recovery can be that a large part of

what was spent on different institutions and under different programs are being paid back or has

already been reimbursed. Some argue that the sub-prime mortgage crisis is unique in a way, that

never before has been the leading national banks so committed to avoid the effects spreading into

other areas of the economy (Kirly-Nagy-Szab, 2008, p. 616).

The third large part of the thesis examines Poland and its behavior since the beginning ofthe crisis. The country showed exceptional resilience to the effects of the crisis. As the rest of

Europe was experiencing more or less severe economic downturn, Poland managed to keep its

head out of the water. Economic growth did not stop, the financial system did not tremble. In this

last part of the thesis, we examine the different causes behind that economic performance. Was it


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merely luck, divine intervention or human action that led to the largest economic growth of the

region in 2009?

One could argue that all the three above had an important role in the economic

performance of Poland in the recent years. As one of the post-socialist countries, Poland has a

relatively short experience of free market economics. Foreign direct investments flowed in large

amounts previous to the crisis, and it has not stopped since then. As a member of the European

Union, Poland used its ability to access the EU Structural Funds efficiently. After entering theera

of free market capitalism, privatization started at a high speed. While it slower than it was in the

first years of the decade, it is still a valuable contributor to the gross domestic product.

As a relatively large country - both by area and population - relies less on export

compared to other countries in the region. When the storm hit Europe, international tradedeclined making the issues more severe for those countries that relied heavily on exports. The

large population of Poland kept its consuming in check, largely neutralizing the effects of slower

trade. While the country has similar trading patterns compared to the other states in Central

Europe, it survived the tempest in a much better shape, sails untorn.

The role of the financial sector in the current crisis is hard to neglect. As the crisis started

to reach Europe, most countries and large banking firms ran stress tests to prove themselves,their

investors and lenders that their position is stable. The Polish banking system proved to be in an

exceptional condition. Not one bank was required to increase its capital or structure to meet

safety standards. As most polish banks had mother institutions abroad, their funding did not dry

out as it did in the United States. Capitalization was not an issue, thanks largely to the actions of

the government: Polish banks were required to increase their capital by retaining profits from

previous years.

Monetary policy was equally healthy, as it focused on long term goals instead of short

term problems. As an aspiring member of the euro area, Poland had its goals set out in time.Inflation, government financing, exchange rates and long term interest rates were are kept in

focus even in the worst months of the crisis. Inflation was kept low, as was unemployment.

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Although fiscal spending increased in the last years, government debt is still relatively low

compared to other states in the region.

Similarly to the United States, Poland had also adopted new laws to cushion the effects of

the global financial meltdown. As the financial system was mostly unharmed, these changes and

actions focused on the middle and small sized actors of the economy. Unemployment benefits

were raised, entrepreneurship was made easier, several barriers against starting and conducting

business in Poland were eliminated. The ongoing process of reforming the pension system didnot

stop, further strengthening our feeling of the long term focus Poland has shown.

As not a member of the euro area yet, Poland was able to use the depreciation of the zoty

to its advantage. Apart from its import reducing impact, Poland converted some of its funds from

the EU at an advantageous rate. At the same time, Polish export became even cheaper, reducingthe effects of declining international trade.

The greatest advantage Poland could have was its recent past. Sound fiscal and monetary

policy decisions highlighted the last decade, which paired with a relatively closed market and

stable economical situation. Government spending, debt levels, inflation and investments allwere

kept at a good level. When the tornado hit, Poland could reinforce investors faith in it, thanks due

to its credibility which was built up in the preceding years. As the first fears passed, Poland

remained a stable economy, more stable than most if its neighbors. And there is little evidence

that the country would do an about-face anywhere in the near future.

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The United States of America and the sub-prime mortgage crisis

Introduction

As of August 2011, the United States was still in an economic downturn caused by a financial

crisis that showed its first signs as early as August 2007, and ended in the first half of 2009. Inthe United States, unemployment doubled between October, 2007 and October, 2010 (U.S.

Department of Labor, Bureau of Labor Statistics, 2011a), trillions of households wealth has

vanished, millions must face foreclosure processes or are behind with their mortgage payments.

The country faces an increasing threat, clearly shown in how hard was to reach an

agreement between Democrats and Republicans on increasing the statutory limit on public debt.

The prolonging debate has led to downgrades by Standard & Poor`s which in turn had led to

higher interest rates to be paid by the United States, further increasing its financial problems. We

will try to draw parallels with the conditions presented in Poland later, for now let us take a look

on the crisis and its roots.

While there is much debate about what were the essential causes of the crisis, several

factors were identified as key components. The weights of these components vary in the eyes of

the different scholars, but most agree that they had a part, some bigger, some smaller in therecent

crisis.

The nine roots of crisis1. Credit bubble Starting in the middle of the 1990s, several international actors, such as China,other large

developing countries, oil-producing nations acquired heavy capital surpluses. These savings were

lent to the West - the United States and Europe in particular -, causing low interest rates. The

Federal Reserve also kept the federal funds rate as low as 1% to help stimulating the economy

following the recession of 2001. Financing riskier investments became easier, as the price of

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borrowing declined. As Frederic Mishkin, former Fed governor told the Financial Crisis Inquiry

Commission on one of its hearings "The System was awash with liquidity, which helped lower

long-term interest rates." (FCIC Report, 2011, p. 107). As the credit bubble emerged in the

United States, it is still in question whether the Fed kept the rates too long too low, or its actions

merely contributed to the credit bubble, but did not cause it. Both former and current Fed

Chairman, Alan Greenspan and Ben Bernanke disagree with the above statement. Chairman

Bernanke argues that the Taylor Rule - often cited as a formula for helping monetary policy

makers for setting the short-term nominal interest rate based on inflation, estimated real interest

rate and economic output - is a rough rule of thumb, and since monetary policy works with a lag,

forecasted values weight more compared to actual ones, thus explaining the interest rates set by

the Fed (Bernanke, 2010).

2. Housing bubble In the late 1990s a large and sustained housing bubble was emerging, andspeeding up in

the early 2000s. This trend happened not only in the United States, but in several countries across

Europe, such as Spain, Ireland or the Baltic countries. There was a direct cause-effect link

between the housing and credit bubbles. Economist Paul Krugman told FCIC, "It`s hard to

envisage us having had this crisis without considering international monetary capital movements.

The U.S. housing bubble was financed by large capital inflows.... It`s a combination of, in the

narrow sense, of a less regulated financial system and a world that was increasingly wide open

for big international capital movements." (FCIC Report, 2011, p. 104).

As for what might have fueled the most the housing bubble itself we can only guess.

While it is clear that population in the "Sand States" (California, Arizona, Nevada and Florida)

grew way faster than the national average, those are only a fraction of the whole United States,

thus it cannot explain the housing bubble alone. Easy financing made it possible to buy more

expensive houses on borrowed money. This does not mean homebuyers could afford those

homes, or would be able to keep up with their mortgages payments in the long run, it simply

means that the loan itself was present and obtainable. We will talk about those predatory lending

practices later.

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3. Nontraditional mortgages and foul lending practices With the help of cheap credit, and thevast inflow of foreign capital into the housing

market, many people chose to have a life beyond their means. Even with the rising housingprices

in the orange states (e.g.: California, Florida), living seemed still affordable with the help ofnontraditional mortgages (Yuliya, 2007). For example the NINJA loans became increasingly

popular, as they required almost no proof that the debtor will be able to repay the loan (No

Income, No Job, no Assests - hence the name NINJA). Due to the investigations following the

crisis, it is clear now that many people were mislead by those whose job was to help and provide

the necessary information. Many were persuaded to sign loan documents, without knowing the

risks and hazards. Mortgage brokers earned based on the value of the mortgage, it did not matter

whether the mortgage was safe, or even affordable by the borrower.

Officials who saw this as a threat asked the only entity to intervene. The Federal Reserve,

under the 1994 Home Ownership and Equity Protection Act (HOEPA) had been granted the

power to issue and enforce new lending rules. Fed Governor Edward Gramlich was on the

opinion, that access to reliable credit can be expanded as long as the proper safeguards are in

place. Attending a conference at the Cleveland State University in 2001, he remarked the lending

practices as "clearly illegal" (Gramlich, 2001). In June 2000, the Department of Housing and

Urban Development and the Treasury Department issued a joint report, which painted a dim

picture about predatory lending practices (U.S. HUD and U.S. Treasury, 2000).

The report also recommended several steps to be taken against such practices. In

December 2001, such changes were made by the Federal Reserve Board through the HOEPA

law, aimed to lower high-interest lending, and to protect against predatory lending practices by

keeping the borrower`s best interest in the focus (FED, 2001, Final Rule on...). As it turned out,

these changes affected only 1% of subprime loans.

4. Credit ratings and securitization Conflicting interests did not exist only at the lower levels of

the mortgage machine, but atits top as well. Credit rating agencies helped to turn hazardous mortgage packages into AAA

rated tranches. As securitization became more and more complex, the rating agencies opinion

became more and more important. Investors relied heavily on these ratings as they bought these

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securities. The different mortgages were packed, distributed, repacked then shipped to investors

around the globe. Many of those mortgage-backed securities were downgraded in the early days

of the crisis, causing billion dollar losses to investors all around the globe. Of all the tranches

initially rated investment grade - from Aaa to Baa - 76% of those issued in 2006 were

downgraded to junk, as were 89% of those issued in 2007.

Moody`s was aware of the problem, but did not try to solve it. Instead of issuing proper

ratings, or updating the mathematical models behind the rating processes, Moody`s issued a mass

announcement hoping to avoid creating confusion. The situation was not any brighter at Standard

& Poor`s or Fitch Ratings either. As these three rating agencies rule the credit rating market -

both Moody`s and S&P each control 40% of the market, while Fitch Ratings is the third biggest

credit rating agency with a market share of 14% - their behavior contributed to the situation.

5. Correlated risk Financial institution across the United States managed to amass very highconcentrations

of highly correlated housing risk. Business size, or sources of funding did not matter. We canfind

large sized, government backed entities such as Freddie Mac or Fannie Mae amassing loads of

housing risk. Both those aforementioned institutions are government-sponsored enterprises

(GSE), " chartered by Congress with a mission to provide liquidity, stability and affordability to

the U.S. housing and mortgage markets" (Fannie Mae, 2011). During the crisis both faced

unprecedented liquidity issues themselves, saved only by the intervention of the Congress.

The managers of those institutions failed to evaluate and manage risks as they made false

assumptions about housing prices. Among these assumptions were the low chance of significant

decline of prices and the uncorrelated nature of housing prices across the nation - a decline in

Montana would not happen parallel to a drop in Texas. With the credit default swaps (CDS)

bought and sold along the mortgage securities line, the effects of these false assumptions were

magnified to the level which brought the end of several financial institutions, as well as people

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6. Leverage and liquidity Due to scarce legislation and lack of proper oversight, the financialinstitutions were able

to further enlarge the problem, by holding too little capital against the risks they were facing. For

example in 2000, the total sum of mortgages either held or guaranteed by Freddie Mac and

Fannie Mae reached $2 trillion. The sum of shareholder equity backing up those mortgages did

not reach $36 billion. It is no wonder those institutions could make a return on equity of 39% and

26% separately (Federal Housing Finance Agency, 2009).

Another common trend was to rely increasingly on short-term financing for day-to-day

liquidity. The "repo" market and the market of commercial papers were the main sources of these

short-term liquidity loans. Commercial paper is an unsecured corporate debt, meaning that it is

not backed by collateral but only by the promise of payment. As these loans were issued for

shorter time periods, they were cheaper as well compared to long term loans. As the commercialpaper market evolved the timeframe became smaller and smaller to the point where corporations

used them on a day to day basis, essentially rolling them over and over.

The market of repurchase agreements (often called "repo") was another source which

enterprises could use for financing resources. These "repos" are contracts of sale and repurchase

at a later date, on the price the assets were sold, followed by an interest for the use of funds.From

a legal point of view, repurchase agreements are a sequence of sale contracts. In essence, "repos"

are short-term, interest bearing loans against collateral. Firms using these sources were often

insufficiently transparent, which ended up in loss of faith and uncertainty in the market that made

it even more difficult to access additional capital or liquidity when it was needed.

7. Risk of contagion The risk of contagion means that the failure of one financial institutionmight bring other

institutions down as well, simply because the level of interconnectedness between them.

Policymakers failed to communicate a clear and coherent image about the government`s role. It

was not clear which institutions might get help, and which were "left alone". This created evengreater uncertainty on the market. Some institutions were deemed too big to fail, meaning

policymakers feared that the fall of these institutions would bring down others as well. Citigroup,

as one of the largest banks were deemed too big to fail. On November 23, 2008, Citigroup agreed

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to the U.S. Government proposal providing a $20 billion capital infusion in exchange for

preferred shares of Citigroup stock (Special Inspector General, 2011).

The effects were immediate. Stock prices stabilized, interest rates on Citigroup`s debt

declined, its access to credit improved. While this intervention did not solve all of Citigroup`s

problems, it helped restoring confidence in the institution. It is worth mentioning, that the U.S.

Government planned so carefully its help, that it endured no losses. Following the restructuring

of its ownership, which left the U.S. Government as Citigroup`s single largest stockholder, the

government even earn profits on its investment in Citigroup by more than $12 billion (SIG,

2011).

8.Common shock As contagion assumes the connections between each and every institution,common shock

refers to a common source, a factor that affects institutions in the same way, at the same time. Inthis case, the common factor was the losses related to the plummeting housing prices in financial

firm in the United States and Europe. Policymakers had to realize they do not face the problem

where only one institution is taking heavy losses due to negative circumstances, but where

several small, large and midsize firms took large losses at the same time.

9. Financial shock and panic September, 2008 was a month a financial disasters. A long andthorough examination

started in the previous months found that the business model of the GSEs (Freddie Mac and

Fannie Mae) was flawed. As both institutions tried to fill Wall Street expectations of growth and

market share while fulfilling their mission of affordable housing goals at the same time, theytook

on increasing risks despite their unsound financial conditions. On September 6, Freddie Mac and

Fannie Mae were presented with the choice of either being taken into conservatorship byconsent,

or having to face "nasty lawsuits" (Lockhart, 2010). Less in two weeks later, on September 15,

Lehman Brothers filed for bankruptcy protection under Chapter 11 (Reorganization) of the U.S.

Bankruptcy Code. The Financial Crisis Inquiry Commission stated that "... the financial crisis

reached cataclysmic proportions with the collapse of Lehman Brothers. Lehman`s collapse

demonstrated weaknesses that also contributed to the failures or near failures of the other four

large investment banks." (FCIC, 2011, p.343).

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Only a day later, on September 16, 2008, American International Group Inc. (AIG) avoids

filing for bankruptcy with the help of a $85 billion rescue from the Federal Reserve. The

government in turn seized a 79.9 % stake in AIG. Panic spread on the market, as news of another

large financial institution`s saw daylight. Washington Mutual Bank was seized by the Office of

Thrift Supervision on September 25, as $16.4 billion of deposits were withdrawn during a tenday

bank run according to John M. Reich, former Director of Office Thrift Supervision (Zarroli,

2008). The Bank and its subsidiaries were later sold to JPMorgan $1.9 billion. According to

Washington Mutual`s 2007 Securities and Exchange Commission (SEC) filing, the companyheld

assets valued at $328 billion (SEC, 2007).

Summary on the roots and nature of the financial crisisAs the inflow of foreign capital providing cheap and easy sources of borrowing paired up

with a rising housing bubble, mortgages and mortgage backed securities soared. Predatory

lending practices, conflict of interest in many levels of the lending machine further contributed to

the problem. When the housing bubble busted, the value of most tranches containing such

mortgages plummeted, causing severe liquidity issues. The high level of interconnectedness

between large financial institutions, and their similar practices in financing meant that most of

those institutions faced the same issues at roughly the same time. Policymakers had to choose

between two actions. Spending taxpayer money saving institutions in hope of containing bank

runs and restoring confidence in those financial institutions or letting those firms fail and

bankrupt and hope that the global financial system will not collapse. No wonder they chose the

former action, as the lesser evil.

Responses to the Crisis by Policymakers

Let us now take a look on what different steps the policymakers and the government took.

As shapers of fiscal and monetary policy the governments - under President George W. Bush and

President Barack Obama - and the Federal Reserve took their responsibility seriously, aiming to

keep the economy running. Their agenda had several key goals: to restore the confidence in the

financial market; to strengthen the financial institutions so they can conduct their business

without government help; to help the families who have lost decades of savings due to the

mortgage crisis or those who faced the threat of imminent eviction due to falling back on their


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mortgage payments. We should not forget that besides these goals the "normal" goals - such as

inflation targets, employment, balance of trade etc. - of economic policy are still present.

The Federal Reserve System

The Federal Reserve System serves as the central banking system of the United States.

Under the Federal Reserve Act of 1913 it was given authority and responsibility to carry out

monetary policy. A major component of this system - besides its central, governmental Board of

Governors and the twelve regional Federal Reserve Banks - is the Federal Open Market

Committee (FOMC). It is made up of the members of the Board of Governors (appointed by the

President and confirmed by the U.S. Senate), the president of the Federal Reserve Bank of New

York, and presidents of four other regional Federal Reserve Banks, who serve on a rotating basis.

The FOMC is mainly focused on open market operations, as one of the main tools to influence

monetary and credit conditions (FED, 2005).

According to Chairman Ben S. Bernanke, the Federal Reserve has responded aggressively

and in an exceptionally rapid and proactive way (Bernanke, 2009). As early as August 17, 2007

the Fed (through FOMC) cut in the discount rate by 50 basis points "To promote the restoration

of orderly conditions in financial markets" (FED, 2007a). Only a month later it was followed by

reducing the target for the federal funds rate by 50 basis points. As economic growth was

moderate in the first half of the year, the credit conditions were thought to have the potential to

enlarge problems in the housing industry, thus reducing overall economic output (FED, 2007b).In the following 12 months, Fed kept cutting back its target for the federal fund rate by a

cumulative 375 basis points, reaching a target of 1% on 29, October 2008. These steps helped to

encourage employment and support incomes in 2007. As the financial markets shook in the fall

of 2008, the economy further deteriorated. As the crisis took global sizes, the leading central

banks took a coordinated move to counter its effects. Critics of the steps taken by Fed argued that

these constant cutbacks stoked inflation. As inflation reached higher levels in 2008 - topping at

5.6 % in July - FOMC expressed its view, that high inflation is mainly fueled by rising raw

material prices in emerging markets.

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With the decline in global economic activity those prices declined, as did inflation as

well. One year later in July, 2009 it reached a more than fifty year low with -2.1% (U.S.Inflation,

2011). These steps were taken to ease the turmoil caused by the increasing turmoil in the

financial markets. With the mortgage crisis, financial institutions found that many of their

traditional funding sources dried up. This forced the Fed to realize easing monetary policy is not

enough, it has to act to keep the credit markets functioning. To reach that goal the Federal

Reserve used a number of additional tools, some of which have only been created when the need

arose.

The first tool in its policy toolkit is communication. As Chairman Ben S. Bernanke stated

"...[The Federal Reserve] should be able to influence longer-term interest rates by informing the

public`s expectations about the future course of monetary policy... if the public were to perceivea

statement about future policy to be unconditional, then long-term rates might fail to respond in

the desired fashion should the economic outlook change materially." (Bernanke, 2009).

The other tools have one thing in common: with using the Fed`s assets they either extend

credit or purchase securities.

The first set of tools relate to the traditional role of a central bank as a lender of last resort.

As the crisis evolved, the Fed made it possible that different financial institutions could turn to

the Fed`s discount window to borrow, thus providing adequate access to short-term credit. As the

crisis further evolved into a global level, the Federal Reserve approved bilateral currency swap

agreements foreign banks. On 6 April,2009, the Fed announced the first of these currency swaps,

working together with the European Central Bank, Bank of England, Bank of Japan and the

Swiss National Bank to provide liquidity for U.S. financial institutions in foreign currency and to

"foster stability in global financial markets." (FED, 2009a).

These steps were insufficient in the way that they did not dissolved concerns about asset

quality and credit risks. To answer this problem the Federal Reserve developed the second set ofits policy tools. As a part of providing liquidity directly to borrowers and investors, the Federal

Reserve created the Term Asset-Backed Securities Loan Facility (TALF), to "help market

participants meet the credit needs of households and small businesses by supporting the issuance

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of asset-backed securities (ABS) collateralized by student loans, auto loans, credit card loans,and

loans guaranteed by the Small Business Administration (SBA)." (FED, 2008a).

The third set of policy tools supported the functioning of the credit market by purchasing

longer-term securities of the Federal Reserve`s portfolio. As Fed announced its plan to purchase

GSE debt and mortgage-backed securities on 25 November, mortgage rates dropped. As the plan

turned into reality, mortgage rates declined even further supporting the recovery of the housing

sector. (FED, 2008b).

The real advantage of these three set of policy tools is that with their help the Federal

Reserve System could further influence interest rates and help credit conditions, despite the

already close-to-zero federal funds rate.

Governmental Responses to the Crisis

Economic Stimulus Act

One of the very first steps taken for mitigating damage and cushioning the effects of the

impending recession was the Economic Stimulus Act (ESA) of 2008. It was signed into law on

13 February, 2008 by President George W. Bush. The Stimulus Act aimed to provide three kinds

of economic stimuli to help economic growth and avert the effects of the looming recession. The

proposal contained elements to increase spending, to help unemployed people and to assist

businesses by reducing their costs.

The Stimulus Rebate for Individuals

Under the Economic Stimulus Act, all eligible individuals (eligible individuals were

taxpayers whose earned income and social security benefits reached $3000 or had a net income

tax liability of at least $1, other than nonresident aliens; an estate or trust; or dependents)received

a fully refundable stimulus rebate credit. The basic credit was $500 plus $300 multiplied by the

number of qualifying children. Most taxpayers received the credit in the form of a check issued

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Election Among Business Stimulus Incentives

The second part of ESA focused on businesses as it offered three options to them.

Qualifying businesses were allowed to elect one of the following incentives: temporary increase

in limitations of expensing certain assets; special depreciation allowance for certain property; or

modification of net operating loss carry back rules. Those incentives existed before ESA, the

stimulus simply enlarged their effects. For example, in the case of temporary increase in

limitations on expensing, the original amounts of $128,000 (the maximum amount a taxpayer

may expense) and $510,000 (the maximum expense is reduced by the amount of cost of property

exceeding this amount) were roughly doubled, to $250,000 and $800,000 respectively - not

indexed for inflation (Joint Committee on Taxation, 2008b).

Extension of Unemployment Insurance Benefits

The last part of ESA aimed to help those who became involuntarily unemployed for

economic reasons and met State-established eligibility rules. Under the Unemployment

Compensation program eligible individuals received extended benefits (EB) for 13 weeks. To be

eligible for such benefits, individuals had to have 20 weeks of full-time insured employment or

its equivalent. The ESA practically doubled this, raising the temporary benefits up to 26 weeks.

The stimulus act also lowered the trigger level for EB period, as the original 5% of insured

unemployment rate within a State was changed to 4% (Joint Committee on Taxation, 2008c).

The Economic Stimulus Act aimed to increase spending by individuals and businessesthrough various tools. There is much debate about whether it was successful in any way or it did

not increase growth of consumption. Some argue - based on surveys and empirical data - that

only 35-40% of the rebates were spent on consuming in the months of 2008, most of the tax

rebates were used to pay off depts or were saved for later use (Saphiro, 2009). According to

government data, consumer spending related to the tax rebates increased economic growth in the

second and third quarter of 2008 by 2,3% and 0,2%, respectively.

Emergency Economic Stabilization Act

As the financial crisis unfolded on the fall of 2008, the Bush administration enacted

Public Law 110-343, "...To provide authority for the Federal Government to purchase and insure

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certain types of troubled assets for the purposes of providing stability to and preventing

disruption in the economy and financial system and protecting taxpayers..." (An Act ..., 2008).

Public Law 110-343 was quoted and referred to as its short title, Emergency Economic

Stabilization Act (EESA). The most important proposal of the law was to set up the Troubled

Assets Relief Program (TARP), a government funded program to help the financial system by

restoring liquidity and stability. Both the Bush and the Obama administration used and expanded

TARP as the need arose. Under TARP several smaller programs were started, which programs

focused on five large areas: (i) financial institutions; (ii) the credit market; (iii) the auto industry,

(iv) American International Group; and (v) housing.

(I) Programs focusing on financial institutions for stabilization purposes:

1. Capital Purchase Program (CPP) - The program was created by the U.S. Department of

the Treasury, to provide capital to financial institutions. As we have already mentioned, tight

connections between the different financial institutions meant that not only industry giants as

AIG needed financial help, but small and middle sized banks as well. This program was

voluntary, as institutions had to agree to sell their shares, and pay dividend based on the

Treasury`s investment - a dividend of five percent in the first five years and nine percent

thereafter (U.S. Treasury, 2011a).

2. Capital Assistance Program (CAP) - CAP was set up to provide additional taxpayer

support for financial institutions. Under the Supervisory Capital Assessment Program (SCAP)financial institutions participated in "stress test", to decide whether they have the capital - in

amount and quality - to withstand a worse-than-expected economic scenario. Out of the ten

largest banking holding companies nine passed the test. GMAC Inc. (now Alley Financial Inc.)

was the only one which was found with insufficient capital and the inability to raise it. GMAC

accessed the TARP Automotive Industry Financing Program to meet its need of $11.5 billion

(FED, 2009b). Under CAP no investment was made.

3. Targeted Investment Program (TIP) - One of the dim realizations of the financial crisis

was that some institutions are simply "too big to fail". The Targeted Investment Program aimed

to further help financial institutions in dire situations, who were considered "systemically

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significant" (U.S. Treasury, 2011b). Under TIP only two institutions received additional help to

their regular CPP investments. Both Citigroup Inc., and Bank of America Corporation sold $20

billion in preferred stocks, after which the Treasury received an eight percent dividend per

annum. As both investments were repaid in December, 2009, Treasury expects TIP to have a

positive return.

4. Asset Guarantee Program (AGP) - As another tool of supporting "too big to fail"

institutions, under AGP the Treasury agreed to absorb unforeseen large losses on certain assets to

improve market confidence (U.S. Treasury, 2008). The Treasury assumed the second-loss

position after Citigroup and Bank of America respectively - those were the only institutions

benefiting from AGP. In exchange, both financial institutions paid a premium for the Treasury,as

well as they agreed to adhere to the guidelines it provided for managing the guaranteedportfolios.

5. Community Development Capital Initiative (CDCI) - While the previous programs

focused on large sized institutions, CDCI was meant to help small and middle sized banks, thrifts

and credit unions. As part of the program, qualifying financial institutions (QFIs) could apply for

investments made by the Treasury on more favorable terms compared to CPP. For example the

initial dividend was 2%, and it rose to 9% after eight years - under CPP minimum dividend was

5%, and it rose to 9% after five years (U.S. Treasury, 2011c). As a rule of thumb the maximum

amount of investment was 5% of the QFI`s risk-weighted assets.

(II) Programs focusing on the credit market

During the peak of the financial crisis, securitization markets almost stopped functioning.

Under TARP, the Treasury committed resources to re-enable to flow of credit, thus mitigatingthe

damages caused to business and households alike. Among the programs initiated, the Public-

Private Investment Program (PPIP) and the Small Businesses and Community Lending Initiative

(SBA7(a)) were the most important.1. Public-Private Investment Program - Launched under the Obama administration on

March 23, 2009, the program aimed to bring capital into the system, and handle legacy realestate

assets. Through private capital and capital allocated from the Treasury under TARP, PPIPcreated


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a strong purchasing power for commercial and non-agency residential mortgage-backed

securities (CMBS/RMBS), helping the rediscovery of prices of said securities (U.S. Treasury,

2011d). PPIP was conducted along three basic guidelines.

Firstly, to maximize the effect of each taxpayer dollar. Second, to minimize possible

losses to the taxpayers - in a downside scenario, private investors lost their entire investment,

while taxpayers shared in returns. Lastly, to minimize the probability that the Treasury would

overpay for said assets, investors from the private sector competing with one another would

determine the price of those assets.

2. Small Businesses and Community Lending Initiative - According to the U.S.

Department of the Treasury " The Obama Administration firmly believes that economic recovery

will be driven in large part by Americas small businesses" (U.S. Treasury, 2011e). As more and

more of those small businesses faced increasing problem to access credit, SBA7(a) tried to

jumpstart their credit market, by purchasing more than $40 billion in securities under SBA7(a)

and other programs such as the American Recovery and Reinvestment Act (ARRA) and the

Small Business Jobs Act (Geithner, 2011).

(III) The Automotive Industry Financing Program (AIFP)

As the automotive industry gave job to more than 1.3 million Americans, its collapse

would have caused unparalleled distress and harm to the United State`s economy (U.S.

Department of Labor, Bureau of Labor Statistics, 2011b). To prevent such down break, the AIFPpromoted stability by providing emergency loans to industry giants close to bankruptcy, such as

General Motors, Chrysler or the already mentioned Alley Financial Inc. (formerly GMAC). (U.S.

Treasury, 2011f).Under AIFP conditions, firms receiving financial aid had to prove that they are

capable of reaching and sustaining long-term viability. Through the program, Treasury invested

more than $80 billion, $50 billion in General Motors, $12.5 billion in Chrysler andapproximately

$18 billion in other companies. As of June 2, 2011, Treasury have recovered half of its

investment in General Motors. As of the above date, Chrysler have almost fully returned all of

the Treasury`s investment - some transactions are still pending (U.S. Treasury, 2011g).

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(IV) American International Group

We have already mentioned AIG`s failure and bailout in the fall of 2008. On September

12, 2008, AIG officials informed the Fed and the Treasury that it is facing fatal problems. As the

largest conventional insurance provider in the world, with assets exceeding $1 trillion, insuring

180,000 entities employing over 100 million people, said institutions deemed it "too big to fail"

(U.S. Treasury, 2011h).After the initial help by the Federal Reserve System, Treasury joined

under TARP the effort to save the insurance giant. As with others receiving serious financial

help, AIG was required to restructure itself to promote long-term stability and viability. Up to

date, Treasury has invested approximately $47.5 billion in AIG under TARP conditions. Ending

January, 2, 2011, AIG exchanged more than 1.5 billion shares for the investments it received

from the Treasury. Selling those shares in the public market is still under way, as it is subject to a

number of conditions, so taxpayers can benefit the most from this particular investment (U.S.

Treasury, 2011h).

(V) Housing programs

With the both the housing and credit bubble burst, an ever growing number of families found

themselves facing increasing mortgage payments and risk of eviction. The two large housing

programs under TARP - Making Home Affordable (MHA) and Hardest Hit Fund (HHF) - are

aimed to help not the reckless, but the "responsible, but struggling homeowners to keep their

homes and reduce the spillover effects of foreclosure on neighborhoods, communities, thefinancial system and the economy." (U.S. Treasury, 2011g).

1. Making Home Affordable - Through various tools MHA promotes stability to

homeowners and the housing market. Said tools include tax credits for homebuyers, using state

and local housing initiatives, foreclosure prevention programs and supporting the two large

GSEs, Freddie Mac and Fannie Mae. Since its announcement in February, 2009, MHA affected

more than 2 million homeowners. More than 30% of those homeowners received a permanent

modification to their mortgages, while the rest of them are on trial modification (U.S. Treasury,

2011i). As of May, 2011, 1,614,723 trials have been started, and 731,451 permanent

modifications have been started. The amount of savings of homeowners who participate in MHA

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is estimated to total more than $6.8 billion, while the average monthly reduction is $525.58 (U.S.

Treasury, 2011j).

2. Hardest Hit Fund - President Obama established Hardest Hit Fund in February, 2010,

to provide additional help to those families living in states hit hard by the crisis. Although a

federal program, each state housing agency is responsible for developing a program, that suits

most the local problems. The key points of every HHF program are the following: (i) mortgage

assistment for unemployed and underemployed; (ii) principal reduction on mortgages; (iii)

funding to eliminate loans; (iv) help homeowners who are moving into more affordable places of

residence. In total, $7.6 billion had been allocated to the participating 18 states (Alabama,

Arizona, California, Florida, Georgia, Illinois, Indiana, Kentucky, Michigan, Mississippi,

Nevada, New Jersey, North Carolina, Ohio, Oregon, Rhode Island, South Carolina, and

Tennessee) and the District of Columbia (Caldwell, 2010). As of July 31, 2011, all of them is

either accepting applications or providing assistance, with California having the largest program

($1,975,334,096) and Washington DC having the smallest ($20,697,198) (U.S. Treasury, 2011j).

TARP overview

Under the Troubled Asset Relief Program, billions of taxpayer money were devoted to

prevent the collapse the financial system, to help stabilizing the economy, to prevent thousands

from losing their jobs and homes. The Program, with its numerous subprograms, has not ended

yet, although it is almost a year now from October 3, 2010, the date when the Treasury`sauthority to make new investments ended. The program were highly criticized, both by

Democrats and Republicans, but is has been successful. As President Obama stated in his Stateof

the Union Speech, January 27, 2010,

"... if there`s one thing that has unified Democrats and Republicans, and everybody in

between, it`s that we all hated the bank bailout. I hated it. You hated it. It was about as popular as

a root canal... But if we had allowed the meltdown of the financial system, unemployment might

be double what is it today. More businesses would certainly have closed. More homes would

have surely been lost. So I supported the last administration`s efforts to create the financialrescue

program. And when we took that program over, we made it more transparent and more

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accountable. And as a result, the markets are now stabilized, and we`ve recovered most of the

money we spent on the banks."

Let us take a look on the facts now. First of all, we cannot say what would have been the

costs of not launching such a program. We can take educated guesses on the different scenarios,

but it all comes down to "what would have happened if". What we can measure directly relatedto

government programs such as TARP is their direct costs. We can compare indicators before the

crisis, under its peak months, and after the different programs were launched. Bothadministration

emphasized the transparency of these programs, that every cent can be followed where, why, and

what for was it spent.

From the $700 billion TARP was authorized to spend, only $475 billion was spent. It is

still an enormous amount of money, but only a fraction (~67%) of what the program`s original

costs were estimated. As we can see from the table below, more than half of the amount spent on

different programs have already been repaid. As not all programs are expected to fully refund

their respective investments, we can safely guess, that most of the billions of dollars spent to

prevent systemic breakdowns were spent at least efficiently.

Table 1. TARP Summary Table

(in billion dollars, Treasury do not expect its housing program expenditures to be repaid. Expenditures of said

programs are made over time.) Source: U.S. Department of the Treasury, Office of Financial Stability: TARP: TwoYear Retrospective

Maximum Allocation

Total Spent

Repayments

% Repaid

Income

Bank capital programs (CPP, CAP, TIP, etc.)

$250 $245 $192 78% $26.8Automotive companies $82 $80 $11 14% $2.6 AIG $70 $48 Credit Market programs

PPIP $22.4 $14.2 $0.43 3% $0.2 TALF $4.3 $0.1 SBA7(a) $0.4 $0.4 Community DevelopmentCapital Initiative

$0.8 $0.6


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Treasury housing programs $45.6 $0.5 n/a n/a n/a Totals $475 $388 $204 53% $29

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As it was made clear several times, taxpayer money was not spent to save the reckless or

to fold holes created by irresponsible behavior. As of following such goals, institutions received

not only financial aid, but stricter regulations and more thorough supervision.

The Dodd-Frank Wall Street Reform and Consumer Protection Act

For such purposes was born Public Law 111-203, signed by President Obama on July 21, 2010.

The Dodd-Frank Wall Street Reform and Consumer Protection Act aimed to end the foul

practices and circumstances which led to the meltdown of the financial system and contributed to

the economic crisis (An Act..., 2010).

First of all, the program created the Consumer Financial Protection Bureau. During the

hearings held by Financial Crisis Inquiry Commission, regulators often cited that they lacked the

proper legislative power to enforce actions that could have stopped the mortgage avalanche. The

Dodd-Frank Act solves this problem, by creating an independent, federal funded institution

which is responsible for consumer protection and authorized to examine regulations andpractices

followed by institutions. As a relatively small agency, and Bureau is able to act fast when it is

needed, as it was given the right to autonomously write rules for consumer protection for all

financial institutions offering consumer financial products or services (U.S. Senate, 2010a).

Second, the Dodd-Frank Act clearly rules out using taxpayer money for bailing out

institutions. To prevent banks and other financial institutions getting "too big to fail", the Act

stated that the newly created Financial Stability Oversight Council has the power to requirelarge,

complex companies to divest some of their holdings if said companies` failure would pose a

grave threat on the financial stability of the United States (U.S. Senate, 2010b).

The Act also created a new office within the U.S. Securities and Exchange Commission.

The Office of Credit Ratings was created to examine Nationally Recognized Statistical Ratings

Organizations (NRSROs) such as Moody`s, Fitch or Standard&Poor`s. Said Office have the

power to effectively down rank such rating agencies if they fail to provide proper ratings overtime. The Act also removed many statutory requirements to use NRSRO ratings, thus providing

incentives to investors for conducting their own analysis. One of the more important parts of the

Dodd-Frank act is that it ended "shopping for ratings". During the investigations following the

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financial crisis, it was made clear that issuers of asset-backed securities picked the agency they

thought would give the highest rating. This created a conflict of interests, as the agencies had to

give good ratings if they wanted to survive on a competitive market (U.S. Senate, 2010c).

Poland and the sub-prime mortgage crisis

Introduction

As the crisis unfolded in late 2009, the international press increasingly turned its attention

on one country in the European Union - Poland. It seemed that a miracle is happening before our

very eyes, as the country seemed to be immune to the effects of the crisis. When this immunity

worn off, Poland kept its prominent place in the region. In 2009, as the Gross Domestic Product

of all EU countries plummeted (by an average of -5.64%), Poland managed to pull out a

seemingly modest 1.65% growth from its magic hat. Only seemingly modest, as it was the only

country which managed to avoid economic recession in 2009 amongst the EU countries.

Unemployment, trade balance and inflation data shows similar trends. Overall, Poland was the

slightest hit and fastest recovering country in the EU. The question is why? What made Polandso

special? How can one explain the resilience and stability the country was able to show? In the

following chapter we will take a look on the key factors, that can explain the difference and shed

some light on the mystery.

The strengths of Poland

Foreign Direct Investments

The first factor we have to take into account is Poland's attractiveness to foreign investors.

After the successful liberalization of the polish economy, the country managed to retain its place

among the most favored countries for investment. As Poland stands right between North and

South, East and West Europe, it has access to the whole European market. But it is not only its

access to huge markets what Poland can offer in the competitive environment. The cost of labor

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foreign capital flowing into the country. Poland managed to keep its first place for almost a

decade as the country receiving most such investments in the region.

Figure 1.: Foreign Direct Investment in Poland and its neighbors, 2000-2010 (net, current US$). Source: WorldBank Database, World Development Indicators & Global Development Finance.

At the start of the decade in 2001, FDI into Poland amounted for $5,714 million. Itincreased more than twofold in merely a few years, to $12,716 million in 2004. FDI inflow

reached its peak during the first year of the crisis, in 2007. Total foreign direct investment

surging into Poland was more than 17 billion USD. This amount has been lowered since then,but

it is still way over what the surrounding countries can show (almost $11 billion in 2008 and more

than $9 billion in 2009) (World Bank Data, 2011A,).

The investments were spread out evenly between the sectors food processing; real estate

and business services and financial intermediation. All three sectors received approximately 23%

of the funds. Around 13% went into trade and repairs, 12% for electricity, gas and watersupplies,

and more than 7% into transport equipment manufacturing. The main sources of FDI to Polandin

2009 were the following countries: Germany (21.6%), France (13.9%), Luxembourg (12.6%),

Sweden (9.5%), the United States (9%), Austria (5.9%), the Netherlands (4,8%), Italy (4.6%)and

Spain (3.9%). The same ratio can be seen in the preceding years as well.

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Figure 2. Foreign Direct Investments in Poland in 2009 by country of origin. Source: World Bank Database; WorldDevelopment Indicators & Global Development Finance

But the effects of FDI are much more spread out. The vast body of empirical literature

shows that multinational firms tend to be larger, more productive, pay higher wages and use

moreadvanced technologies and systems compared to domestic firms. This in turn affects wages; the

skills of domestic labor force; and with workforce turnover those advanced techniques will

become more and more common in the real economy.

Privatization tends to attract foreign direct investment, as it could have been witnessed

from the example of Poland. As the privatization process was started, almost one fourth of FDI

was related to privatized enterprises. When the process reached its peak in 2000, it slowed down

as did FDI flows related to privatization (Wojnicka, 2001, p.7).

International and domestic trade

With its 312,685 sq km territory, and 38,441,588 population, Poland is a force to be

counted with. It is the sixth largest country in the European Union by population, and the ninth

largest by territory. Compared to other similarly developed countries, Poland is less reliant on

exports for its economic growth.

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Figure 3.: Export - Import as % of same year GDP. Source : Source: World Bank Database; World DevelopmentIndicators & Global Development Finance

As one can see, exports have not reached 41% of Poland's GDP in the previous years,

while for example Hungary's reliance on exports for its economic growth is much heavier, as the

same indicator has not been under 60% for the same examined period.The structure of export and import has not changed much in recent years. In 2010, exports

totaled 120,373 million euro. Poland mostly exports machinery and transport equipment(41.1%),

manufactured goods classified chiefly by material (20.27%), miscellaneous manufacturedarticles

(12.84%), food and live animals (9.23%), mineral fuels, lubricants and related materials (4.10%)

(Yearbook on Foreign Trade, 2011, p.48-50).

Germany has been the main target of polish export since the late 1980's, taking the place

of the USSR in 1990 with a relatively large share of 26.2%. France and Italy are the next biggest

importers of polish goods with 6.9% share each. The fact, that we can find the same countries in

the same order for more than a decade now shows, that Poland has its international trade routes

and customs well built.

The structure of imports is quite similar to the structure of exports. The bulk of imports

are made up from machinery and transport equipment (34.28%), manufactured goods classified

chiefly by material (17.82%), chemical and related products (14.26%), mineral fuels, lubricantsand related materials (10.73%).

Most foreign goods come from Germany (21.9%), with Russia (10.2%) and China (9.4%)

following. Since the fall of the Soviet Union, Germany has stepped up as the major trading

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partner for Poland, with 1995 marking the tightest trading relations. Almost forty percent(38.3%)

of all Polish foreign trade went to Germany, while every fourth foreign good was marked with

"Made in Germany". Although Germany has kept its role as a major trading partner, its relative

weight decreased to 26.1% of all exported goods.

In one of his speeches, Marek Belka, President of the National Bank of Poland has spoken

about the many factors that resulted in the exceptional resilience the country showed during the

crisis. Of these factors were one of the most important the relatively smaller dependence on

external demand and the relatively stable internal demand. However, we should not forget that

the large domestic market is more of a talent than a skill. That is, the sound macroeconomic

policy had little to do with the sheer size of the internal market (Belka, 2010, p.3).

Currency depreciation

As the faith in almost every market was shaken, the emerging East European Countries

were severely hit. The lack of confidence was leading to an uncontrolled depreciation of the

region's currencies, and runaway depreciation was the only serious threat to the stability of the

Polish banking system (which had a moderate, though significant, amount of foreign currency

exposure). In March 2009 (before Poland's IMF credit line was finalized) the government

undertook a program of selling Euros from EU funds, as the then-highly depreciated zloty

allowed these funds to be converted at a particularly advantageous rate.

But the depreciation had positive effects as well. Most importantly, Polish export became

effectively cheaper, thus helping to mitigate the damage caused by the declining demand for

Polish goods and services in the international market. On the other hand, import became more

expensive at the same time, which resulted in less consuming of foreign goods.

Policy makers realized that when most of eastern and central Europe was viewed as crisis-

zone, one of the most important goals is to restore investors faith and the confidence of the

markets in the country. A most welcomed side effect was of the aforementioned sales that the

depreciation was halted and to some extent even reversed.

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The larger share of small and medium-size, owner-managed firms in Poland's economy

also certainly played an important role in the country's success. Poland's work force has one of

the largest shares of entrepreneurs in all of Europe, and they proved highly resilient to the shock

of the crisis, and flexible in their response to it. By rapidly cranking up the absorption of EU

funds, the government also helped maintain demand and sustain an adequate level ofinvestments.

Monetary Policy and the Banking System

Another of the most influential factors helping Poland to avoid a deep recession was its

sound economic policy, not only during the crisis but well before it first showed signs of its

existence. Both monetary and fiscal policy makers made sure that medium and long terminterests

have priority over short term goals and election cycles.As the National Bank of Poland (Narodowy Bank Polski) has made it clear several times,

its first and utmost goal is to promote price stability and reach its inflation targets. In its first

longer term strategy, NBP announced a target inflation of 3-4% in 1999 (National Bank of

Poland, 2003, p.16). Poland indeed reached that goal, as inflation declined after a short rising,

reaching almost 12% in 2000 but getting as low as 1.9% in 2002, now succesfully following its

inflation target goal of 2.51%.

This could not have been reached by using only the strategies NBP used prior 1999: the

strategy of maintaining a stable exchange rate and the strategy of controlled money supply

growth.

Maintaining a stable exchange rate meant difficulties for the NBP: (i) how to determine

the correct equilibrium exchange rate; (ii) the Polish economy was susceptible to the adverse

developments in the country the Zloty was pegged; (iii) and it could not do much to cushion the

effects of domestic shocks.

Controlling the money supply is the best tool for monetary policy when the link between

monetary aggregates and inflation is predictable. In the case of Poland, NBP had to face someserious restrictions due to the facts, that (i) the structure of the banking sector distorted central

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bank signals to the real economy; and (ii) the exchange rate mechanism did not guarantee control

over money supply, as with the rise of foreign capital inflowing into the country increased its

effect on money supply as well.

Mostly for the reasons above, NBP decided to shift over those strategies, and focused on

direct inflation targeting (DIT). Among its positive effects are (i) it being simple - it is more

comprehensible by economic agents; (ii) it enhances policy credibility - its openness means it is

harder to use for short-term goals; (iii) and greater flexibility compared to controlling aggregate

money.

In its second Monetary Policy Strategy dated to 2003, NBP stated that the previous

strategy and the tools outlined above were highly successful. As the time for joining the

European Union drew closer, joining the European Monetary Union became a reachable goal. In

order to fulfill the requirements , often cited as the Maastricht criteria, Poland renewed its focus

on inflation, fiscal spending, exchange rate and long term interest rates (OECD, 2008, p.47).

As part of the Maastricht criteria the ration of the annual government deficit to same year

gross domestic product must not exceed 3% (temporary exception can be granted for exceptional

cases). By 2007, Poland has reduced its deficit to 2% of GDP, which is even lower than the

Maastricht criterion.

This miracle was not done in a few days thou. It was reached by tight fiscal measures,

aimed to reach said goal over a course of years. Before the crisis, its peak was in 2006, whendebt

to GPD ratio reached 6.3%. In the years following the crisis, the ratio increased reflecting the

fiscal actions taken to cushion its adverse effects, reaching 7.8% in 2010 and currently hovering

around 5%.

In its 2008 Convergence Programme, Poland expressed its view on an increasing deficit

in 2008, while stating that a steady consolidation will follow. With reducing income taxes in

2009, and co financing EU funded infrastructure programs, the deficit of 1% earlier aimed at

soon became unreachable.

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Although not strictly linked to monetary policy, we have to mention the Polish financial

and banking system briefly. As a result of sound, non-cyclical fiscal policies in the previous

decades, the external debts of both government and households were kept at a manageable rate.

Several down-to-top bank tests conducted in Poland proved that the banking system can

withstand severe economic scenarios, as it indeed did during the crisis. The country managed to

further avoid the contagion of the financial system, thanks to its lower short-term debt to reserves

ratio, thus negating the possibility of liquidity runs (Agnor, 2003, p. 1099).

Capitalization was also sufficient in all cases, although most banks received some kind of

financial assist from their respective mother banks. It is also important, that government required

banks to retain their profits from fiscal year 2008 and use it to cushion the impending effects of

the financial crisis. Again a clear sign of sound policies!

It was also important that many of the practices and tools causing the financial meltdown

in the United States were mostly unknown in the Polish banking sector. The relative

underdevelopment is not uncommon in the region. As many states have only a short history of

free market capitalism, Poland also started with the absence of know-how and lack ofexperience.

While this proved to be helpful for our case, it also should be noted that a higher developed

banking sector would promote further economic growth, while helping better absorption of FDI

flows at the same time (European Central Bank, 2005, p. 14).

Fiscal Policy and Legislative Changes

During the crisis, Poland and its policymakers showed exceptional resilience as they

continued to carry out medium and long term programs. Privatization did not stop, as the country

has expressed its strong belief in free market economics many times now: Public ownership is

one of the key steps leading to efficient and growing market entities. Several reforms planned

previous to the crisis were still carried out, as the government kept the long run in its focus.

In the years preceding the crisis, Poland had managed to decrease its government deficit,

from 6,3% in 2003 to 1,9% in 2007, thanks to higher than expected tax revenues and lower

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expenditures. Using the favorable economic context to their advantage, fiscal policy makers

decided to launch a series of broad reforms, touching as diverse areas as taxation; working

conditions and entrepreneurship; and the pension system. These reforms showed their impact on

the government budget in turn, raising it to 7.3-7.8% in the last two years.

The aim of the taxation reforms was to lower the tax wedge, and it was reached through a

series of different steps. In 2007, child tax credit was introduced, to help middle income families.

This was followed by decreasing the social security contributions in the next year. Personal

income tax rates were also changed, although it took three years to implement after it has been

voted. As of 2009, there is it only two tax keys for personal income taxation: 18% for a tax base

not exceeding PLN 85,528, and 32% of base exceeding said amount (OECD, 2010, p.36).

We can find prime examples of how Poland avoided these actions in the different Acts

and Amendments that were signed into law in 2009. These legislative tools aimed to promote

economic growth, stability and to dampen the effects of the ongoing crisis (Miller, 2010A, p.2)

The amending of Bankruptcy and Remedial Act, Bank Guarantee Fund Act and National

Court Register Act was also a part of these tools. Under these acts, it was made easier to file for

bankruptcy, with the goal of improving those enterprises instead of eliminating them. It was also

made possible to use not only monetary liabilities - as it had been before - but every liability

applying entrepreneur may have to use in the bankruptcy proceeding. As the Acts made it

possible for a broader range of entrepreneurs to apply for remedial proceedings, it proved andincentive to seek help when their financial problems still can be resolved (ibid, p.3).

Under the above amendment, it was made possible, for the first time in Polish legal

system, to file for consumer bankruptcy. It means, that a petition can be filed by the debtor to

declare bankruptcy by a natural person, not engaged in economic activity. The bankruptcy can be

declared if insolvency was not the fault of the debtor, it occurred due to exceptional

circumstances over which the debtor had no influence. Losing employment by the consent or as a

consequence of one`s own behavior did not count as exceptional circumstance (Act on the

Freedom of... , 2004).

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Another fine example of such steps taken is the Amendment of the Act on the Freedom of

Economic Activity (Ustawa o Swobodzie Dziaalnoci Gospodarczej). All of the Amendments

made in March, 2009 were aimed to make entrepreneurship easier in Poland, and thus increase

economic growth.

First of all, it prevents any public administrator to decide about starting, conducting or

terminating a business based on extra requirements over those set out in regulations. It is no

longer possible for authorities to demand extra documents or data. This severely limits

administrative power and its possibilities to make decisions against entrepreneurs based on

requirements not legally binding. The Amendment clearly highlighted a route, where

administration and entrepreneurs work in mutual relations, as equal partners.

Registering a business entity was also made easier. For example, one can file the

necessary documents through the internet, applying for a range of administrative requirements -

taxpayer identification number, statistical numbers etc. - at the same time, thus shortening the

time between filing for a new business and starting business to the extent of conducting business

on the day applications were filed (some restrictions apply, for example in areas where startingor

undertaking business requires special permission or concession).

The most important part of the Amendment is probably how it changed relating

definitions. As it changed the different thresholds different type of entrepren

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The subprime mortgage crisis in USA and Poland

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