Topic 1: Housing Market
bursting of the US...
Effects of the 2007-2009 Financial Crisis on US Financial Market and Institutions
Topic 1: Housing Market
bursting of the US housing bubble, the result of the recklessness of the US
financial market, is largely is to blame for the 2007/2008 financial crisis and
the subsequent global recession. The Housing market was, therefore, one of the
sectors to be visibly shaken by the crisis. Real estate prices plunged (Altman,
2008; Cook, 2008; Feldstein, 2009; Marshall, 2009). The fall in the prices of
houses saw mortgage defaults and foreclosures rise sharply, increasing the
“supply of homes on the market” (Feldstein, 2009, p.1). This caused the prices
of houses to fall further. Consequently, by 2009, a third of all American
homeowners who had mortgages were already ‘underwater’, meaning that “their mortgage
debt exceeded the value of the house” (Feldstein, 2009, p.1), with the debts of
20 percent of those homes higher than the house value.
Topics 2 & 3: Financial Institutions
and the Financial Market
early as March 2008, major financial institutions had started experiencing problems,
when Bear Stearns, one of the US’s largest investment banks, nearly collapsed
and was only saved by JP Morgan Chase, which acquired it with FED’s backing (Dufour
& Orhangazi, 2014).
problem got worse between September and October 2008. During this time, US
experienced a severe financial dislocation that led to the collapse of a number
of its large financial institutions. The first institution to fall was the investment
bank Lehman Brothers, which filed Chapter 11 bankruptcy on 15 September 2008. On
that very day, Merrill Lynch, also an investment bank, was purchased by the
Bank of America for $50 billion. Soon, only Morgan Stanley and Goldman Sachs
were the remaining investment banks. On 21 September, they became bank holding
companies and gained greater access to capital. Just four days later, on 25
September, the federal Deposit Insurance Corporation seized the assets of
Washington Mutual, a savings and loan giant, transferring most of them to the
JP Morgan Chase (Marshall, 2009; Dufour & Orhangazi, 2014).
the collapse of these institutions, the global financial market became even
more volatile. Around this time, the Dow Jones Industrial Average (simply known
as Dow), which comprises of 30 of world’s largest publicly-listed companies, experienced
tumultuous shifts every day, registering its largest ever “single-day point
drop in value on 29 September 2008” (Marshall, 2009, p.8). This volatility
continued until December, Dow ultimately experiencing “four of the five highest
point gains and losses in its history” (Marshall, 2009, p.8). This volatility led
to a dramatic fall in investor confidence, evident in the flight of safer assets
such as the US dollar, oil and gold.
volatility of financial market spread to other parts of the world. Although the
housing market is said to be the lead cause of the financial crisis, it is the
complex “web of financial innovations that is said to have made it possible for
the crisis to spread across the financial markets” (Kornecki, 2013, p.7). Credit
channels tightened in Europe too. In London, for instance, the 3-month
interbank offer rate (known as LIBOR) exceeded the interest received on
three-month Treasury Bill, capturing the perceived credit risk and growing counterparty risk, the latter
also having exploded around the same time, September and October 2008 (Marshall,
Topic 4: Failure of High
the financial crisis saw the collapse of a number of high profile firms in the
US, in the financial and other sectors. These include Lehman Brothers, Bear
Stearns, Fannie Mae and Freddie and Merill Lynch.
Stearns had grown into a large American investment bank, one of the largest in
fact. This growth was attributed to its heavy engagement in mortgage-backed securities
during the years of housing bubble. With the financial crisis, however, it was
one of the earliest affected financial institutions. With the crisis, mortgage
default and delinquency rates continued to rise and, among other mortgage
lenders, Bear Stearns faced problems with the continued fall of the value of
collateral or even the assets that had been used to secure housing-related
loans. It was unable to recapitalize sufficiently to address its many losses,
so when stock prices fell in March 2008, it was damaged severely. Nearing
collapse, it was saved when it was acquired by JP Morgan Chase (with the
assistance of the government) on 16 March (Dufour & Orhangazi, 2014).
Mae and Freddie Mac
to Demyanyk and Hemert (2008), there are several explanations for the increased
generous credits granted to the riskiest borrowers in the years leading to the
financial crisis, one being that the Congress, as well as the Clinton and Bush
administrations, pressured government-sponsored enterprises (GSEs), such as
Fannie Mae and Freddie Mac, to lower mortgage standards for low-income families
and establish a home-ownership society. Fannie Mae and Freddie Mac abided.
According to Marshal (2009), in 2004, only 10 percent of Fannie Mae and Freddie
Mac’s new mortgages were supported by these GSEs. But the government pushed,
even its Chief risk officer getting fired in 2004 for suggesting the
institution should tighten its mortgage standards. Therefore, from mid-2005, the
institution’s subprime lending increased dramatically. It undertook a flurry of lending for the years
of housing bubble, and even as the bubble was starting to burst.
when the bubble burst, subprime loans became the biggest victims. The
foreclosure rates of these loans rose from 4.5 percent to 8 Percent between the
fourth quarters of 2006 and 2007. At the same time, the rate of foreclosure for
adjustable-rate subprime loans soared by more than twice (from 5.6 percent to
13.4 percent). This hit Fannie Mae and Freddie Mac severely, which was then taken
over by Fed in September 2008 (Marshall, 2009).
Lynch was one of the firms that nearly went bankrupt except for a last minute
sale to the Bank of America that saved it. In the midst of the crisis, in 2007
and 2008, Merrill Lynch reported a loss totaling $35.8 billion. Partly what contributed
to this fall was the firm’s excessive expenditure in employee bonuses. Reaping
the profits of the bubble, Merrill Lynch spent a lot of money in employee bonuses.
In 2008, it spent in excess of $1 million from a total bonus package of $3.6
billion even though it lost $27 billion.
the root of the problem was the firm’s reckless activities in the financial
market in the years leading to the crisis, owing to lack of government
regulation. For instance, it invested too much in subprime loans. As June 2008
came to a close, the firm held $41 billion worth in subprime mortgage bonds and
CDOs. This value exceeded its firm’s entire shareholders’ equity at the time
(standing at $38 billion) (Crotty, 2009). When the real estate market
experienced fallen prices and increased mortgage defaults and delinquencies, Merrill
Lynch came crumbling down hard.
have argued that the government could have saved Lehman Brothers, one of the
largest investment banks when the financial crisis began. Indeed, having failed
to raise the capital necessary to underwrite its downgraded securities, the
government sure needed financial help. However, that financial aid did not
materialize, showing the government’s unwillingness to bail out banks and causing
an instant spike in the lending rates between banks. Lehman Brothers filed for bankruptcy
protection on 15 September 2008 (Harress & Caulderwood, 2013).
American International Group (AIG), a leading credit defaults insurer, had suffered
an acute crisis liquidity as a result of the crisis in September 2008,
particularly following the downgrading of its credit rating. According to
Crotty (2009), AIG also reaped significant profits during the bubble,
especially through its Financial Products unit which flirted with credit
default swaps. But it was that unit that would face the first problem when the
bubble burst, losing $40.5 billion in 2008. Still, even with the crisis already
biting, AIG continued to behave recklessly as it did during the good years,
that very year (2008) spending $220 million in bonuses.
Bear Stearns, it was also saved from total collapse when on 16 September 2008, just
a day after the collapse of Lehman Brothers, the government authorized the
Federal Reserve Bank of New York to lend it (AIG) a sum of up to $85 billion,
but in exchange for 79.9 percent equity (Marshall, 2009).