Behind the Financial Crisis: Causes and Fall-outs
The world watched as the U.S. financial system failed, comparable to stock market crash of 1929, the days of Wall Street’s Investment Banks are over.
Investment banks and brokerage firms make money by buying and selling stocks and bonds, helping companies go public, issuing new stocks or bonds, and by creating investment vehicles for customers (such as aggregating and repackaging loans of all types). Everything is fine as long as there is something to sell customers and that there are customers to buy the products that these firms create.
The summer of 2007 saw the start of the Subprime Mortgage Crisis, Americans could no longer afford their adjustable rate mortgages and their over-priced homes; the loan defaults and foreclosures began. The difference between this real estate bubble and the ebbs and flows of real estate in years past is that these loans, including the subprime loans, were repackaged and sold widely as low-risk investments and became sources of capital for many of the investment banks and brokerage firms, who then sold them again to investors interested in making money with high yields and low risk. The crisis that hit Bear Stearns, Lehman Brothers, Merrill Lynch, AIG (as well as Fannie Mae), was that there were no buyers for the repackaged sub-prime loans and no place to unload the debt that these companies incurred.
Making matters worse was the use of borrowed funds or “leverage,” in which these companies borrowed huge amounts to buy stocks/securities/other investments, and then when they sold these investments for a profit, they made exorbitant amount of money. In 2007, Lehman had $700 billion in investments; its shareholders investments (equity) was about $23 billion, the rest of the funds were supported by borrowing, a “leverage” ratio of 30:1. The use of leveraged funds provides a huge incentive to focus on short-term profits, which fueled the buying of the subprime mortgages. At one point, Fannie Mae and Freddie Mac had leverages of 60:1. The use of leveraged funds backfired when these investments could no longer be sold.1
The failure of the subprime market though is only one of the many contributing factors. While the full-picture might not unfold for years, there are other known contributing factors, such as credit default swaps, to the current financial crisis.
The Role of Credit Defaults Swaps (CDS)
Credit default swaps work similarly to insurance contracts, which cover losses on certain types of securities, such as municipal bonds, corporate debt, and mortgage securities, when the institution taking out the debt defaults. The institution/person that buys the credit default insurance pays a premium in return for default coverage. Any institution can buy these contracts, even if they were not the ones to take out the debt. These contracts can be “swapped” or traded, without knowledge that the buyer actually has the resources to pay off the contract in case of default.
Unlike insurance policies, credit swaps are not regulated, are often done in private deals, and may go through as many as 15-20 trades. Again, similar to the sub-prime crisis, risk is very hard to assess and the values of these “credit default swaps” are hard to measure.2
A mid-2007 estimate puts the CDS market at $45 trillion dollars; commercial banks this time are the main holders of CDSs, with the top 25 banks holding $13 trillion in CDSs. The banks acted as both the insured and the insurer. The reason this market ballooned was because this money was viewed as easy money, with premiums coming in, and low expectations that they would have to be paid out.
The failure of subprime market, will hit the CDS market hard because there is so little transparency about the holders of these contracts and their abilities to pay off the debt. The failure of AIG, Bear Stearns, and many of the other recent failed financial institutions is tied to their CDS holdings. The fall-out of a CDS crisis will have huge repercussions. Loans will be even more difficult to get, since banks will not readily provide default insurance. Companies, municipalities who raise capital by bonds and other debt mechanisms will have problems raising money.3
The repercussions of the financial crisis
The worst-case scenario that is mentioned is depression, which could be as bad as the U.S. Great Depression! Since the U.S. government will try its hardest to avert this level of crisis, $700 billion dollars will most likely be given to bail out financial institutions in trouble, albeit with some caveats. Then what?
The U.S. financial system will be re-organized. Already Goldman Sachs and Morgan Stanley will have commercial bank branches, which will raise capital through individual accounts. These banks will have to follow specific investment rules, such as lower leverage. The marriage of brokerage firms, investment banks, and commercial banks, will change the number and type of investment instruments available to the public and to institutions who want to raise funds.
Start-ups and small companies will have hard times raising money, since they will be viewed as risky. Investments that are not FDIC-insured may fail. Overall, there will be less liquidity, so fewer loans to individuals and to companies and the loans which will be given, will have higher interest rates attached.
The U.S. economy will slow. Less money will be available for aid, for non-profits, for service industries that rely on wealthy consumers to support them, and, of course for homes. Since the U.S. financial system is globalized, economies around the world will slow as well. The Russian Stock market already fallen 55 percent and the Chinese stock market fell by 48 percent.4
Many countries may choose a different currency for their reserves, if faith is lost in the dollars value. At the end of 2007, $9.4 trillion dollars of dollar-dominated securities were being held by foreign investors.5 If the dollar loses its reserve status, then gold may be a beneficiary. The British pound used to be the currency of international transactions, two world wars reduced its value and slow growth led to interest in other currencies, such as the U.S. dollar.
Moving Forward
A U.S. government bail-out is crucial. It will hopefully stave off the most dire consequences. But it will be just the first step to increasing transparency of the inner-working of the financial world. Policy and regulation is needed to make sure that the CDS market is cleaned up soon, so that it does not further destabilize the world economy.
Eventually, the other root cause of this crisis, the sub-prime loans and the decreasing value of real estate will need to be addressed, so that more home foreclosures do not further weaken the financial system.
Some recommend decreasing the leverage ratios permitted by companies, thus further decreasing risk from financial markets. Some risk will always be a part of the system, but it must be properly assessed and transparently reported.
Many Americans balk at their tax-money being used to bail out these institutions and to taking on the risk associated with these bad loans. But as many pundits note, the alternative is worse. (globalization101.org)
Investment banks and brokerage firms make money by buying and selling stocks and bonds, helping companies go public, issuing new stocks or bonds, and by creating investment vehicles for customers (such as aggregating and repackaging loans of all types). Everything is fine as long as there is something to sell customers and that there are customers to buy the products that these firms create.
The summer of 2007 saw the start of the Subprime Mortgage Crisis, Americans could no longer afford their adjustable rate mortgages and their over-priced homes; the loan defaults and foreclosures began. The difference between this real estate bubble and the ebbs and flows of real estate in years past is that these loans, including the subprime loans, were repackaged and sold widely as low-risk investments and became sources of capital for many of the investment banks and brokerage firms, who then sold them again to investors interested in making money with high yields and low risk. The crisis that hit Bear Stearns, Lehman Brothers, Merrill Lynch, AIG (as well as Fannie Mae), was that there were no buyers for the repackaged sub-prime loans and no place to unload the debt that these companies incurred.
Making matters worse was the use of borrowed funds or “leverage,” in which these companies borrowed huge amounts to buy stocks/securities/other investments, and then when they sold these investments for a profit, they made exorbitant amount of money. In 2007, Lehman had $700 billion in investments; its shareholders investments (equity) was about $23 billion, the rest of the funds were supported by borrowing, a “leverage” ratio of 30:1. The use of leveraged funds provides a huge incentive to focus on short-term profits, which fueled the buying of the subprime mortgages. At one point, Fannie Mae and Freddie Mac had leverages of 60:1. The use of leveraged funds backfired when these investments could no longer be sold.1
The failure of the subprime market though is only one of the many contributing factors. While the full-picture might not unfold for years, there are other known contributing factors, such as credit default swaps, to the current financial crisis.
The Role of Credit Defaults Swaps (CDS)
Credit default swaps work similarly to insurance contracts, which cover losses on certain types of securities, such as municipal bonds, corporate debt, and mortgage securities, when the institution taking out the debt defaults. The institution/person that buys the credit default insurance pays a premium in return for default coverage. Any institution can buy these contracts, even if they were not the ones to take out the debt. These contracts can be “swapped” or traded, without knowledge that the buyer actually has the resources to pay off the contract in case of default.
Unlike insurance policies, credit swaps are not regulated, are often done in private deals, and may go through as many as 15-20 trades. Again, similar to the sub-prime crisis, risk is very hard to assess and the values of these “credit default swaps” are hard to measure.2
A mid-2007 estimate puts the CDS market at $45 trillion dollars; commercial banks this time are the main holders of CDSs, with the top 25 banks holding $13 trillion in CDSs. The banks acted as both the insured and the insurer. The reason this market ballooned was because this money was viewed as easy money, with premiums coming in, and low expectations that they would have to be paid out.
The failure of subprime market, will hit the CDS market hard because there is so little transparency about the holders of these contracts and their abilities to pay off the debt. The failure of AIG, Bear Stearns, and many of the other recent failed financial institutions is tied to their CDS holdings. The fall-out of a CDS crisis will have huge repercussions. Loans will be even more difficult to get, since banks will not readily provide default insurance. Companies, municipalities who raise capital by bonds and other debt mechanisms will have problems raising money.3
The repercussions of the financial crisis
The worst-case scenario that is mentioned is depression, which could be as bad as the U.S. Great Depression! Since the U.S. government will try its hardest to avert this level of crisis, $700 billion dollars will most likely be given to bail out financial institutions in trouble, albeit with some caveats. Then what?
The U.S. financial system will be re-organized. Already Goldman Sachs and Morgan Stanley will have commercial bank branches, which will raise capital through individual accounts. These banks will have to follow specific investment rules, such as lower leverage. The marriage of brokerage firms, investment banks, and commercial banks, will change the number and type of investment instruments available to the public and to institutions who want to raise funds.
Start-ups and small companies will have hard times raising money, since they will be viewed as risky. Investments that are not FDIC-insured may fail. Overall, there will be less liquidity, so fewer loans to individuals and to companies and the loans which will be given, will have higher interest rates attached.
The U.S. economy will slow. Less money will be available for aid, for non-profits, for service industries that rely on wealthy consumers to support them, and, of course for homes. Since the U.S. financial system is globalized, economies around the world will slow as well. The Russian Stock market already fallen 55 percent and the Chinese stock market fell by 48 percent.4
Many countries may choose a different currency for their reserves, if faith is lost in the dollars value. At the end of 2007, $9.4 trillion dollars of dollar-dominated securities were being held by foreign investors.5 If the dollar loses its reserve status, then gold may be a beneficiary. The British pound used to be the currency of international transactions, two world wars reduced its value and slow growth led to interest in other currencies, such as the U.S. dollar.
Moving Forward
A U.S. government bail-out is crucial. It will hopefully stave off the most dire consequences. But it will be just the first step to increasing transparency of the inner-working of the financial world. Policy and regulation is needed to make sure that the CDS market is cleaned up soon, so that it does not further destabilize the world economy.
Eventually, the other root cause of this crisis, the sub-prime loans and the decreasing value of real estate will need to be addressed, so that more home foreclosures do not further weaken the financial system.
Some recommend decreasing the leverage ratios permitted by companies, thus further decreasing risk from financial markets. Some risk will always be a part of the system, but it must be properly assessed and transparently reported.
Many Americans balk at their tax-money being used to bail out these institutions and to taking on the risk associated with these bad loans. But as many pundits note, the alternative is worse. (globalization101.org)
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