Effects of the 2007-2009 Financial Crisis on US Financial Market and Institutions

Topic 1: Housing Market

The 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

As 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).

However, 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).

Following 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.

This 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, 2009).

Topic 4: Failure of High Profile Firms

Indeed, 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.

a)   Bear Stearns

Bear 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).

b)   Fannie Mae and Freddie Mac

According 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.

Unfortunately, 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).

c)   Merill Lynch

Merill 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.

But 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.

d)   Lehman Brothers

Some 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).

e)   AIG

The 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.

Like 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).