The Present Financial Crisis Faced by the Banks, Essay Example

“It was never meant to happen again, but the world economy is now mired in the most severe financial crisis since the Great Depression” (United Nations 1). Triggered by the burst of the United States housing bubble, the financial crisis has gained worldwide proportions and started to drag global economy into a severe recession. Coming into power in the middle of the 2007 and into 2008, the global financial crisis caused the world stock markets to fall dramatically, large financial institutions to collapse or to be bought out with governments all over the world having to come up with rescue packages to bail out their financial systems (Patrick). The consequences of the crisis can be witnessed almost in all fields of human practice and are of the major concern for the economists and politicians all over the world. What we are going to discuss in this paper is the affects the financial crisis has on the national banking system with an emphasis on its primary causes, already established consequences and remedial solutions.

It is widely acknowledged nowadays that the recent market instability as well as the global financial crisis both have their roots in the American real estate and subprime lending collapses, caused, on the one hand, “by the dramatic change in the ability to create new lines of credit, which dried up the flow of money and slowed new economic growth and the buying and selling of assets” and, on the other hand, “by the cheap credit, which made it too easy for people to buy houses or make other investments based on pure speculation” (Patrick). The American economy is built on credit, which is a great tool when used wisely. But in the last decade, credit went unchecked in our country: mortgage brokers, acting only as middle men, determined who got loans, passing on the responsibility for those loans on to others in the form of mortgage backed assets. Risky mortgages became commonplace and the brokers, who approved these loans, absolved themselves of responsibility by packaging these bad mortgages with other mortgages and reselling them as “investments.” Thousands of people took out loans larger than they could afford in the hopes that they could either flip the house for profit or refinance later at a lower rate and with more equity in their home – which they would then leverage to purchase another “investment” house. But many of these mortgage backed assets were ticking time bombs. And they just went off. The housing slump set off a chain reaction in our economy. Individuals and investors could no longer flip their homes for a quick profit and thousands of mortgages defaulted, leaving investors and financial institutions holding the bag. This caused massive losses in mortgage backed securities and many banks and investment firms began bleeding money (Patrick). Depressed housing prices caused further complications as it made many homes worth much less than the mortgage value and some owners chose to simply walk away instead of pay their mortgage. These caused many banks to tighten their lending requirements, but it was already too late for many of them – the collapse has already started: Fannie Mae (FNM) and Freddie Mac (FRE) were both taken over by the government; Lehman Brothers declared bankruptcy on September 14, 2008 after failing to find a buyer; Bank of America agreed to purchase Merrill Lynch (MER), and American International Group (AIG) was saved by an $85 billion capital injection by the federal government (Andrews, de la Merced, and Walsh). Shortly after, on September 25, 2008 J P Morgan Chase (JPM) agreed to purchase the assets of Washington Mutual (WM) in what was the biggest bank failure in history (Ellis and Sahadi).

“September 2008 marked a sea change in the international financial landscape, including the end of the independent investment banking in the United States and an end to previous faith in the virtues of unfettered financial markets” (United Nations 11). Between September 2007 and October 2008, 16 banks in the United States filed for bankruptcy, and more than 100 out of some 7000 banks are on the Fed’s watch list. “While this proportion is still small compared with the Great Depression, when about 700 out of all 9000 banks failed, its ramifications in an integrated financial world are every bit as big” (United Nations 11). In November 2008, the United States Government also had to come to the rescue of the Citigroup, backing about $306 billion in loans and securities and investing $20 billion directly in the financial institution considered too important to fail (United Nations). As a result of the emerging banking collapse, retail businesses and industrial firms, both large and small, are finding it increasingly difficult to obtain credit as banks have become reluctant to lend, even to long-time customers. Financial institutions are doing their best to save and withdraw their assets with the purpose of maintaining liquidity.

Various steps have been taken by the Government to deal with the financial crisis and support the national banking system but these seem to be easier sad than done. The primary solution was President Obama’s $787 bailout plan, which intended to buy out the risky mortgage backed securities from financial institutions, giving the banks the opportunity to lend more money to individuals and businesses, hopefully spurring on the economy. President Obama also noted that the plan – a package of tax cuts and spending, the approved version of which is split into 36% for tax cuts and 64% percent in spending and money for social programs – will “save or create more than 3.5 million jobs” (“U.S. Congress Passes Stimulus Plan”).  The U.S. Federal Reserve has taken steps to expand money supplies to avoid the risk of a deflationary spiral, in which lower wages and higher unemployment lead to a self-reinforcing decline in global consumption. The Central Bank has also purchased a significant sum of government debt and troubled private assets from banks, which was the largest liquidity injection into the credit market, and the largest monetary policy action, in world history (Altman).

In June 2009 American President Barack Obama and key advisers introduced a series of regulatory proposals. The proposals address consumer protection, executive pay, bank financial cushions or capital requirements, expanded regulation of the shadow banking system and derivatives, and enhanced authority for the Federal Reserve to safely wind-down systemically important institutions, among others (“Remarks by the President on the 21^st Century Regulatory Reforms”). A variety of regulatory changes have been proposed by economists, politicians, journalists, and business leaders to minimize the impact of the current crisis and prevent recurrence. However, many of the proposed solutions have not yet been implemented. Among those, for example, are Ben Bernanke’s initiative of establishing resolution procedures for closing troubled financial institutions in the shadow banking system, such as investment banks and hedge funds (“Federal Reserve Policies in the Financial Crisis”), Eric Dinallo’s suggestion to ensure any financial institution to have the necessary capital to support its financial commitments, regulating credit derivatives and ensuring they are traded on well-capitalized exchanges to limit counterparty risk (Dinallo), and Nouriel Roubini’s proposal of the nationalization of the insolvent banks and reduction of the mortgage balances to assist homeowners, giving the lender a share in any future home appreciation (A Conversation with Nouriel Roubini).

All in all, in accordance with the U.S. Federal Reserve Open Market Committee Press Release in June 2009:

“…the pace of economic contraction is slowing. Conditions in financial markets have generally improved in recent months. Household spending has shown further signs of stabilizing but remains constrained by ongoing job losses, lower housing wealth, and tight credit. Businesses are cutting back on fixed investment and staffing but appear to be making progress in bringing inventory stocks into better alignment with sales. Although economic activity is likely to remain weak for a time, the Committee continues to anticipate that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will contribute to a gradual resumption of sustainable economic growth in a context of price stability”.

The stabilization of the economic and financial markets is projected around 2010 with the potential growth of the GDP levels, strict unemployment rates moderation as well as the return of the inflation rates to typical levels.

Work Cited

A Conversation with Nouriel Roubini. 14 Oct. 2008. 27 Jul. 2009. http://www.charlierose.com/view/interview/9310

Altman, Roger C. “The Great Crash, 2008.” January/February 2009. 27 Jul. 2009. http://www.foreignaffairs.com/articles/63714/roger-c-altman/the-great-crash-2008

Andrews, Edmund L., de la Merced, Michael J., and Walsh, Mary Williams. “Fed’s $85 Billion Loan Rescues Insurer.” NY Times [New York] 16 Sept. 2008.

Dinallo, Eric. “We modernized ourselves into this ice age.” 30 Mar. 2009. 27 Jul. 2009. http://www.ft.com/cms/s/0/3b94938c-1d59-11de-9eb3-00144feabdc0.html?nclick_check=1

Ellis, David, and Sahadi, Jeanne. “JPMorgan buys WaMu.” CCN Money 25 Sept. 2008.

“Federal Reserve Policies in the Financial Crisis.” Chairman Ben S. Bernanke’s Speech at the Greater Austin Chamber of Commerce, Austin, Texas, 1 Dec. 2008. 27 Jul. 2009. http://www.federalreserve.gov/newsevents/speech/bernanke20081201a.htm

“FOMC Press Release” 24 Jun. 2009. 27 Jul. 2009. http://www.federalreserve.gov/newsevents/press/monetary/20090624a.htm

Patrick. “The 2008-2009 Financial Crisis – Causes and Effects.” 29 Sept. 2008. 27 Jul. 2009. http://cashmoneylife.com/2008/09/29/economic-financial-crisis-2008-causes/

“Remarks by the President on the 21^st Century Regulatory Reform.” 17 Jun. 2009. 27 Jul. 2009. http://www.whitehouse.gov/the_press_office/Remarks-of-the-President-on-Regulatory-Reform/

United Nations. World Economic Situation and Prospects 2009. United Nations Publications ICTY, 2009.

“U.S. Congress Passes Stimulus Plan.” 14 Feb. 2009. 27 Jul. 2009. http://news.bbc.co.uk/2/hi/business/7889897.stm