The subprime mortgage crisis in USA and Poland

Abstract

The sub-prime mortgage crisis of the United States has grown into a global recession in a few years. As the  financial 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 the markets "work it out" on their own. Keynesian economics started to bloom again, fiscal and monetary interventions could be witnessed across the globe. In this paper we focus on three large key areas of interest while trying to answer one important question: What can be learned of the recent years? While we try to answer that question we examine three larger topics. First of all, how the current financial and economic crisis started. What were the major underlying causes of the financial breakdown? Was it avoidable or even preventable by the proper actions of either economic actors? In the second part, we examine what path did the United States of America choose to avoid 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 the economy running"? In the last part we turn our focus to a distinctively different country, Poland. As it is different by its 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 try to 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 par ticipating 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 ex amined in  proper depth due to the tangible and intangible constraints of a such paper. p aper. 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 understand how it all began. As to picking Poland against Hungary I have very simple reasons. Influenced  by my studies at the Cracow University of Economics (Uniwersytet Ekonomiczny w Krakowie), and

spurred by the excellent economic performance Poland has shown in recent years I decided not to wade into the frail topic of Hungary, leaving it for another time, maybe another paper. Most of  5 | Page

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 and even 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 6 | Page

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 and credit  bubbles burst. Prices of mortgage backed securities plummeted, trading stopped. Credit ratings were changed overnight, tranches rated AAA became worthless in hours. The effects rippled through 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 7 | Page

 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 (Győrffy, 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 went on, 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 have  been 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 securities from 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 8 | Page

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 were spent 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 to unemployment 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 always generated 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, 9 | Page

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 to  bail out institutions, even those deemed "too big to fail" is not out of the question. The foul practice of  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 (Király-Nagy-Szabó, 2008, p. 616). The third large part of the thesis examines Poland and its behavior since the beginning of  the 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 the era 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 trade declined 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. 11 | Page

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 did not 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 złoty 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, reducing the 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 all were 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. 12 | Page

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. In the 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 the recent crisis. The nine roots of crisis

1. 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  13 | Page

 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, and speeding 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. 14 | Page

3. Nontraditional mortgages and foul lending practices With the help of cheap credit, and the vast inflow of foreign capital into the housing market, many people chose to have a life beyond their means. Even with the rising housing  prices in the orange states (e.g.: California, Florida), living seemed still affordable with the help of  nontraditional 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 at its 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 15 | Page

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 high concentrations of highly correlated housing risk. Business size, or sources of funding did not matter. We can find 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 losing their homes. 16 | Page

6. Leverage and liquidity Due to scarce legislation and lack of proper oversight, the financial institutions 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 commercial  paper 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 institution might 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 even greater 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 17 | Page

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. In this 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 and thorough 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, they took  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 by consent, 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). 18 | Page

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 ten day  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 company held assets valued at $328 billion (SEC, 2007). Summary on the roots and nature of the financial crisis

As 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. 20 | Page

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 perceive a 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 of  its 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 21 | Page

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  by the Department of Treasury (Joint Committee on Taxation, 2008a). 22 | Page

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 businesses through 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 23 | Page

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 24 | Page

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 guaranteed  portfolios. 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 mitigating the damages caused to business and households alike. Among the programs initiated, the PublicPrivate 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 real estate assets. Through private capital and capital allocated from the Treasury under TARP, PPIP created

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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 America’s 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 AIFP  promoted 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 and approximately $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). 26 | Page

(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, the financial 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 27 | Page

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`s authority 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 State of  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 financial rescue  program. And when we took that program over, we made it more transparent and more 28 | Page

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 related to 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. Both administration 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: Two Year Retrospective

Maximum Allocation Total Spent Repayments % Repaid Income Bank capital programs (CPP, CAP, TIP, etc.) $250 $245 $192 78% $26.8 Automotive 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 Development Capital Initiative $0.8 $0.6

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

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 and  practices 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 require large, 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 over  time. 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 30 | Page

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 Poland so 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  has been lower in Poland than in Western Europe for more than a decade now. This resulted in 31 | Page

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: World   Bank Database, World Development Indicators & Global Development Finance.

At the start of the decade in 2001, FDI into Poland amounted for $5,714 million. It increased 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 water  supplies, and more than 7% into transport equipment manufacturing. The main sources of FDI to Poland in 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. 32 | Page

 Figure 2. Foreign Direct Investments in Poland in 2009 by country of origin. Source: World Bank Database; World   Development 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 more advanced 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. 33 | Page

 Figure 3.: Export - Import as % of same year GDP. Source : Source: World Bank Database; World Development   Indicators & 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 manufactured articles (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, lubricants and 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 34 | Page

 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 crisiszone, 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. 35 | Page

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 of  investments. 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 term interests 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 2.5±1%. 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 some serious restrictions due to the facts, that (i) the structure of the banking sector distorted central 36 | Page

 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, when debt 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. 37 | Page

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 (Agénor, 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 of  experience. 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  38 | Page

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 and incentive 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). 39 | Page

Another fine example of such steps taken is the Amendment of the Act on the Freedom of  Economic Activity (Ustawa o Swobodzie Działalności 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 starting or  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 entrepreneurs must have met, more became eligible to conduct business, or apply for public aid. A new entrepreneur was also introduced, the micro-entrepreneur. Micro-entrepreneur is a trade, who in the last two fiscal years has employed no more than 10 employees and his net turnover or assets did not exceed the PLN equivalent of € 2,000,000 at the end of either fiscal year. The limits for small and medium entrepreneurs are 50 and 250 employees, and €10 million and 50 million respectively (Polish Information and ..., 2011). The Amendment is only one example of the sound and stable policies that Poland pursued in the recent years. As it improved the conditions for starting a business it acted as an economic 40 | Page

stimuli, to promote growth and consuming. It is clearly a different approach compared to the tax rebates witnessed in the United States, but not less helpful. Another fine example of sound macroeconomic policies is how the pensions system was changed in Poland. The fact that Poland finished its pension reform during the crisis, also testifies on its commitment for long-term goals. The polish pension system faced challenges not unique to the country: (i) it served as a buffer during the transformation period, as the number of retirees in 1991 was almost threefold compared to the previous and following years; (ii) consequently, as the ratio of pensioners to working population increased. The latter part put an increasing pressure on the medium-long term budget, which had to be changed to promote stability. The system was changed from a one pillar Pay-As-You-Go method, to a two pillar one, where the second pillar is made up from open pension funds (OPFs). Membership to OPFs was mandatory for new entrants to the labor market, while being voluntary for other workers. These new funds were limited on their investment possibilities, with maximum 5% foreign investments, a maximum of 40% domestic equities, while the ratio of treasury bonds was not specified. By eliminating several possibilities of early retirement, the reform effectively increased retirement age to 60/65 for women and men. Bridging pensions were designed for those who work in particular conditions or whose profession is specific of nature (Fedak, 2010, p.6). This not only tried to act as a remedy for the labor shortages, but also to help the budget. In the case of  Poland, public expenditures on early retirement schemes as percent of GDP were considerably higher compared to average in the European Union (OECD, 2008, p. 66). One of the many appraisals the International Monetary Fund has expressed towards Poland was related to the current state of the pension system and its former reforms. As the government chose to implement the changes as early as possible, the weight of aging population does not put that much stress on the fiscal outlook than in many of similar countries (International Monetary Fund, 2009, p.27). 41 | Page

To sum up, the Polish authorities’ response to the crisis has been very good. Monetary  policy has been loosened significantly, which was the right thing to do as the economy slowed. As to fiscal policy, the authorities have underscored their determination to limit the increase in the deficit while constantly focusing on their long term goals. Like a number of its neighbors, Poland also benefited from a significant depreciation of the zloty during the crisis.  Summary

As to the question, why was Poland able to ship in the economic turmoil while other  countries sank no easy answer can be found. Several factors helped the polish economy surviving the crisis. Interestingly, one of them is the fact, that the economy was less developed. For  example, reliance on export was low; the financial system was not penetrated by the most recent type of securities. When those securities caused major distress across the globe, Poland was seen as left out of those problems. Having a more closed market turned out to be a good thing this time (Király, 2009, p. 324). Its vast internal market helped keeping consumption at level, substituting internal demand for the decrease of exports. FDI flows did not decrease at a level that it would have caused major distress. The banking system was sound and stable, properly capitalized, without the fear of liquidity issues. Although general government deficit rose in 2007-08, almost doubling from 1.9% to 3.6% as it was kept at a quite low level. In the years following, the deficit started to rise, and now seems to be stopped at the 8% mark, amounting for 7.3 and 7.8 as  percentage of the GDP. It is also important to note, that Poland had just finished economic reforms on multiple levels by the time the crisis unfolded in Europe. The pension reform eased its relating burdens on the budget and making and conducting business in Poland never has been easier. One of the most important thing Poland had, was its sound fiscal and monetary policy  before the crisis. Inflation were kept in check; unemployment was steadily declining; government debt and deficit were kept at manageable levels. The previous `good years` gave both the time and the possibilities to prepare for the coming crisis. After examining our case, it is less wondrous now how could Poland withstand the tornado in such a good shape. The good decisions made again and again since the start of the

42 | Page

decade left Poland in a much stronger shape than the countries around. It is clear that the crisis had much less strength in places where things were kept in check. The unbalanced, wounded economies were the most severely hit during the storm. The contagion could also be tracked to the countries where such imbalances were more profound. Where was no trouble, the financial markets could not do much harm (Király, 2007, p.312). It could worth further research how much electoral cycles affected government spending, as several authors argue that the greatest advantage Poland has its will to compromise on all levels from between the Sejm and the Senate about government spending to employees and employers debating on working conditions and wages. 43 | Page

Conclusions We wanted to examine the causality of the sub-prime mortgage crisis, and how two distinct countries - the United States and Poland -managed with its challenges. As the crisis itself  is a still ongoing process, we have to be careful when wording conclusions, as there is still events to be witnessed, lessons to be learnt. But there is also room for experiences to be drawn, points to make. While one can argue, that every crisis is unique, the sub-prime mortgage crisis is unique in many ways. The main root of it was the steep rose of mortgage defaults in short period of  time, causing rippling effects throughout the financial system. The mortgage backed securities lost their values overnight, trading stopped, market prices were unaccounted for. Key institutions faced severe liquidity issues, as they relied mostly on day-to-day borrowing backed by securities  becoming worthless. As the signs of systematic weakness spread, so did panic and the masses started to lose confidence in their banks, pension funds, in themselves. Both the Bush and Obama administrations tried to cushion the effects. Costly programs were launched to save big and small. Some institutions were deemed too big to fail, some were left to their downfall. This created further chaos and panic, as the governmental intervention seemed to lack logic. There are many explanations why Lehman Brothers were left alone, but American International Group was not, ranging from conspirator theories to simple human error. Scapegoats were found in most levels of the sub-prime securitization market. Predatory lenders, faulty computer models, greedy borrowers, irresponsible behavior and risk taking in the top seats of industry giants. While some say that loose monetary policy and the lack of legislative power to stop foul lending practices contributed most to the crisis, we think that households, financial institutions and government share the responsibility in equal terms for the situation. Current thesis did not examine the pros or cons of the originate and distribute model, or its links to the turmoil we are still witnessing. Securitization was not the sole cause of the effects, merely one of many. 44 | Page

One of the real learning experiences of the crisis will be to see what it really was. Was is an earthquake, shaking everything to its very core, leaving ruins and devastation on its wake? Was it merely a test of financial markets and products, to decide which goods are worthy of trade and which are spoiled beyond recovery? Or we should welcome the storm, as it will leave a clear,  blue sky after having spent its wrath? We think that the sub-prime mortgage crisis was similar to the last picture, a cleansing rain. Securitization market did exists before the crisis, working and fostering economic growth and welfare. With the spread of collateralized debt obligations and credit default swaps lacking  proper background, the system became contaminated. But the correct answer cannot be the devolution of financial markets and institutions. While a grip too firm can lead to suffocation,  proper balance have to be found in supervising the financial markets and the products offered. The lessons of Poland are very different. While they may seem trivial, their implications may go a long way. Simply put, the strength of Poland was itself. The government and the households did not change their core ideas: dedication towards free market economics, solidarity and cooperation in the most possible levels. The sound fiscal and monetary policies followed in the years before the crisis bore their  fruits. Poland went ahead in terms of proper capitalization in its banking system, or releasing  pressure through the pension system reforms. Clear headed use of currency depreciation, improving entrepreneurship conditions, promoting long term goals over short term issues are all important signs. As the crisis reared its ugly head up in the most developed countries first, the lesser  developed and smaller countries cannot look at them for help. One could argue that Poland was lucky, to have a trade balance or a size of domestic market like it had. But it was no luck that formed the decisions about lending rates, capital requirements or privatization, it was sheer  determination. The implications for Hungary are quite dim. One cannot hope to cope up with the  performance Poland has shown without similar dedication towards fiscal tightness or long term monetary goals. 45 | Page

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