This Article gives an overview of a series on the causes and impact of the financial crisis. The other practice notes in the series are:

In early summer 2007, the US and Europe experienced a sudden reduction in the general availability of credit (variously described in the media as a credit squeeze or credit crunch). By October 2008, it had escalated to a full blown financial crisis.

The credit crunch was triggered by the bursting of the US housing bubble that had encouraged speculation by house builders, homebuyers and mortgage lenders (US house prices increased by 124% between 1997 and 2006).

House price increases had been fuelled by cheap credit extended to risky borrowers on a massive scale as lenders competed against each other to achieve best available yield on their loans. The US subprime mortgage market grew from $160 billion to $540 billion between 2001 and 2004, according to trade publication Inside Mortgage Finance.

Mortgage originators extended subprime mortgages. Financial institutions used securitization to pool these mortgages together in "bankruptcy remote" special purpose vehicles (SPVs) that issued mortgage-backed securities (MBSs) to investors. The MBSs were themselves repackaged and bundled together into other securities known as collateralized debt obligations (CDOs).

Credit rating agencies used statistical models to assign credit ratings to MBSs and CDOs. Investors such as hedge funds, investment banks, pension funds and insurance companies around the world relied on these ratings to invest in MBSs and CDOs. Individuals within banks were effectively encouraged to make high risk investments which offered short term gains, because these gains drove their bonus payments.

To protect themselves from the risk of borrower defaults, investors often bought credit default swaps (CDSs). In theory, CDSs should have insulated investors from the effects of defaults. However, it became clear that CDSs had actually helped spread the effects of defaults and created uncertainty about who had what credit exposure to whom.

As subprime borrowers began to default on their mortgages, the value of MBSs fell and the market for them became illiquid. Investors had to mark-to-market their investments and suffered huge paper losses.

The lack of transparency as to which financial institutions were exposed to subprime-related losses and the uncertainty over the size of the losses to which those exposures would give rise made financial institutions unwilling to lend to each other. The liquidity shortage exposed the underlying structural weaknesses within the banking system, including over-reliance by some banks on inter-bank lending.

By August 2008, financial institutions around the world had recognized subprime-related losses and write-downs exceeding $501 billion, according to figures from Bloomberg. September 2008 brought a series of market-transforming events, including Lehman Brothers' bankruptcy.

The US government has responded to the financial crisis with a range of measures intended to loosen credit markets and increase investor confidence, including expanding banks' cash sources, giving them some protection against borrower default, providing a funding backstop for commercial paper issuers, facilitating the sale of money market instruments in the secondary market and providing relief for consumers and small businesses. Similar measures have been adopted internationally.

The response has evolved to take account of the changing situation. For example, plans to remove troubled assets from banks' balance sheets were dropped in favor of direct investment in debt or equity, but the government subsequently indicated that the strategy may shift again to also target troubled or "toxic" assets. On February 13, 2009, Congress approved the American Recovery and Reinvestment Act of 2009 (ARRA). The ARRA contains an estimated $787 billion in new spending measures and tax cuts designed to jump start the economy. As a result of these new initiatives, further government programs are expected.

However, it is far from clear whether these measures will be sufficient to thaw the current freeze. There are some promising indications (for example, in the commercial paper market) but there are concerns that banks will continue to hoard bailout funds or use them to make acquisitions rather than extend credit.

The financial services industry has also undergone significant changes with several major bank consolidations, investment bank conversions to bank holding companies and bank reorganizations reducing the number of lenders and arrangers and adding to the instability and uncertainty in the market.

One wider consequence of the bailout has been the "me too" factor: non-financial companies such as automobile manufacturers have also benefitted from government aid. A significant task facing the government is deciding where to draw the bailout line.

The turmoil in the credit markets and the losses suffered by banks, mutual funds, companies and ordinary investors have already resulted in a number of high-profile lawsuits.

The initial litigation concentrated on acquisitions affected by the market events. In 2009, the focus will likely shift to financially distressed companies.

The focus will also move to parties that have suffered losses as a consequence of the financial crisis, such as stockholders, borrowers and employees, and the market participants to whom they attribute the blame, including credit rating agencies, mortgage lenders and the directors and officers of troubled financial institutions.

For further background on the causes and effects of the financial crisis, see Article, Financial Crisis Series: Causes and Effects. For information on the impact of the financial crisis in the UK, see Practice Note, Financial crisis: Q&A (UK).

Participants in the capital markets are facing increased regulation and challenging market conditions as a result of the financial crisis.

In the short term, the SEC introduced rules to protect investors against naked short selling (that is, selling stock short without making arrangements to borrow it in time for delivery to the buyer) and placed additional disclosure and other requirements on credit rating agencies.

Looking to the future, SEC Chairman Cox also asked Congress for jurisdiction to regulate CDSs.

Before the financial crisis, it was thought that CDSs made the financial system more secure and efficient by spreading the risk of default across a larger number of investors. However, as credit defaults began to occur, it became clear that CDSs actually amplified the effect of those defaults: a single default could send ripples across the whole financial system.

In addition, CDSs created uncertainty. The market is still largely unregulated and there is no public information about who owns which CDSs, which meant that in practice it was impossible to know who had what credit exposure to whom.

In the future, more extensive federal regulation of the whole CDS market is almost inevitable.

Issuers seeking financing in the capital markets face challenging market conditions. Follow-on offerings and financial sector equity issuances dominated the capital markets in 2008, while initial public offerings (IPOs) were at their lowest volume since 2003 (Thomson Reuters). There is little appetite for debt in general, with investors demanding increasing spreads for high-yield debt.

To the extent that public companies are raising capital, they are doing so in a much tighter time frame. There is an emerging practice whereby certain eligible issuers who already have an effective shelf registration statement on file with the SEC bring a limited number of potential investors "over the wall" to market a deal before announcing the deal publicly.

This means they provide these selected investors with material non-public information and make oral offers to sell securities, before they actually announce their intent to make an offering to the public. This eliminates the risk of announcing an offering when there is insufficient market appetite because the issuer has effectively already sold the deal before it announces it (the time frame for this can be as short as overnight or over a weekend).

For more on CDSs and the impact of the crisis on capital markets, see Article, Financial Crisis Series: Impact on Capital Markets.

The financial crisis has affected all sources of financing from commercial paper to syndicated loans, leading to decreased liquidity, decreased lending and higher borrowing costs.

Companies have had to refinance their commercial paper on a daily or weekly basis at ever increasing interest rates. They have also had to free up cash and draw down on longer-term financing to repay commercial paper that has fallen due. Loans are trading at a significant discount (as low as 65 to 70 cents in the dollar) in the secondary market.

To secure their anticipated future cash needs, some borrowers have preemptively drawn down existing lines of credit. They are also looking closely at any yank-a-bank provisions in their credit agreements which enable them to replace lenders that fail to fund their commitments. However, such provisions offer little practical comfort for borrowers in the current market, as replacement lenders are hard to find.

Lenders continue to be reluctant to extend new long term financing to even the most creditworthy borrowers. Where they are doing so, it is often at an original issue discount, so that the borrower in practice receives less than the total principal it has borrowed.

Demand for financing from Chapter 11 debtors-in-possession is high, but DIP financing is especially scarce. This may force more companies into liquidations rather than successful workouts.

Where financing is available, borrowers are operating in a more hostile lending environment. The easy terms of 2006 have vanished and lenders are looking at terms that give them greater protection when the markets are disrupted and greater control (through tighter covenants) when borrowers run into financial difficulties.

So far as possible, borrowers are avoiding giving lenders the opportunity to renegotiate terms of existing credit agreements. By contrast, lenders are demanding strict compliance with covenants and have looked to invoke "market disruption" provisions where interest rates have failed to cover their actual cost of funds.

At the same time, the failure of major financial institutions has focused borrowers' attention on the credit worthiness of their lenders, and on the practical effects of bank bankruptcy.

For more on the impact of the financial crisis on loans and credit markets and on the implications of bank bankruptcies, see Article, Financial Crisis Series: Impact on Loans and Credit Markets.

One of the most significant effects of the financial crisis has been a dramatic increase in the number of companies in financial difficulty.

Companies in financial difficulty have a range of restructuring options, all of which present opportunities for investors in distressed assets (see Impact on M&A and Private Equity below). Outside of bankruptcy, the principal options are exchange offers, debt/equity swaps, debt restructuring, debt tender offers, asset sales and capital raising. Bankruptcy itself offers a number of restructuring options: traditional Chapter 11 proceedings, prepackaged bankruptcy (or prepacks) and prearranged bankruptcy.

Where a company is in the "zone of insolvency", its board of directors needs to take particular care as they may need to consider the interests of the company's creditors as well as the interests of the stockholders and the company itself.

Even where a company is not in the "zone of insolvency" there are a number of practical steps directors should be taking in light of current market conditions. These include systematically monitoring the company's financial condition, maintaining good corporate governance practices and, for public companies, keeping disclosures under close review.

In addition, all companies should monitor their relationships with third parties, including finance and insurance providers. Companies should review their exposure to major customers and suppliers and take prompt action (such as building up inventory of vital supplies, promptly pursuing customer payments and reducing reliance on single suppliers) to minimize the risks should those customers or suppliers experience financial difficulties.

Even companies with a solid liquidity position have been affected by dramatic falls in stock prices and interest rates as securities investors liquidate their portfolio investments. For a number of companies, particularly companies in the technology sector, this presents an opportunity to repurchase their own securities at bargain prices. Amazon.com, Microsoft Corp. and Nike, Inc., are among the companies seeking to reduce their debt and income expenses or support their stock's trading price by buying back their own securities.

For more on the impact of the financial crisis on companies, see Article, Financial Crisis Series: Impact on Companies.

The immediate effect of the financial crisis on M&A and private equity has been a dramatic reduction in the leveraged buyout activity that had dominated headlines in 2005-07. Private equity-sponsored buyouts are down approximately 74% from 2007.

The crisis has led to an unprecedented number of renegotiated and terminated deals, several of which ended up in court before they were resolved. Litigation in relation to matters such as reverse break-up fees and material adverse event (MAE) provisions is expected to change the way parties negotiate and document acquisitions.

The shift to a buyers' market has triggered a number of other changes in market practice, with buyers looking for greater flexibility to walk away from deals, while at the same time forcing sellers to accept less freedom to do so. Where deals have taken place, they have tended to be considerably smaller. Financiers have expected private equity sponsors to put in more equity and have not been prepared to lend on such easy terms.

Challenging economic conditions are pushing an increasing number of companies into financial difficulty, and this presents attractive opportunities for buyers of distressed companies or assets, including private equity buyers that still have large reserves of equity and undrawn credit lines as well as strategic buyers that have been forced out of the running in the last few years. Special considerations apply to the purchase of the assets of distressed companies and structuring these transactions demands particular care.

Longer term, private equity faces a looming crisis of its own. Private equity funds typically have a three- to five-year time horizon to return funds to investors and will be looking to exit investments they made in 2005 before 2010. In addition, significant numbers of portfolio companies saddled with unmanageable debt may eventually slide into bankruptcy, notwithstanding the easy loan terms and low interest rates that became commonplace in 2006-07. In the future they will have to focus more on finding value through eliminating operational inefficiencies rather than through increasing leverage.

For more on the impact of the financial crisis on M&A and private equity and on the special considerations that apply to purchasing the assets of a distressed company, see Article, Financial Crisis Series: Impact on M&A and Private Equity.

In the long term, the financial crisis will lead to increased domestic and international regulation of the financial sector to reduce systemic risks and increase transparency.

To address regulatory failings, the federal regulatory bodies themselves may be reformed and, in some instances, supplemented or replaced. Regulators and central banks around the world have already taken unprecedented coordinated action in response to the crisis and face increased pressure to work together (although international political agreement on a new supra-national regulator is unlikely).

The crisis has already prompted consolidation in the financial sector and changes in the way that businesses in the financial sector organize themselves. Further consolidation is likely to follow.

Financial reporting practice has already been clarified and the SEC delivered a report to Congress in December 2008 recommending against the suspension of the fair value accounting standards. In addition, the Financial Accounting Standards Board and the International Accounting Standards Board have formed a joint advisory group to review reporting issues coming out of the financial crisis.

More widely, the financial crisis has shifted the balance of power between the state and the market. Government bailouts of the financial sector and more recently of the auto industry, and the government's new role as an equity stakeholder in some of the US's largest financial institutions, will have a lasting impact both in the financial sector and beyond. As a result, checks have already been imposed on top executive compensation at institutions participating in the bailout.

On a practical level, the financial crisis has led market participants to reassess the allocation of risk in transactions.

The first and most obvious signs of this have emerged in relation to finance transactions, where lenders are looking at terms to give them greater protection when the markets are disrupted and greater control when borrowers run into financial difficulties. However, the financial crisis is also having an impact on all kinds of business arrangements from simple commercial agreements to complex business combinations.

The expected wave of securities litigation will have significant implications for all market participants and is also likely to lead to lasting changes in market practice. In addition, commercial litigation in relation to matters such as reverse break-up fees and MAE provisions is changing the way parties negotiate and document corporate transactions generally.

For more on the long-term implications of the financial crisis, see Article, Financial Crisis Series: Long-Term Implications.