The Financial Crisis Of 2008 Finance Essay

The Financial Crisis Of 2008 Finance Essay There were many economic and political factors that lead to the financial crisis of 2008. Specific regulations, companies overstepping their boundaries with leverage, and the housing market bubble are only a few that have been said to have caused it. All of these factors were very important, and some of them are still happening today. The following four companies were on the front pages of almost every newspaper during this time, Bear Stearns Co., Lehman Brothers Holding Inc., Washington Mutual, and JPMorgan Co. To understand how these companies became major players in the financial crisis, the history of the companies must be shown. Bear Stearns Co. began when three men named, Joseph A. Bear, Robert B. Stearns and Harold C. Mayerà ¢Ã¢â€š ¬Ã‚ ¦ [Invested] $500,000 in capital to start one of the biggest independent investment banks in history. (11) Bear Stearns Co. came to be an extremely strong company. During the stock market crash, the firm [laid] off none of its employees. (11) Bear Stearns was always a strong company and it was not until 2007 that the company had its first quarterly loss. (11) To investors of a public company, over eighty years of profits means someone is running the company right. But once that first loss happened, the stock price sunk for the first time in company history. Lehman Brothers Holding Inc. was originally a small shop (4) that Henry Lehman opened when he moved to Alabama. After [Henrys] death in 1855à ¢Ã¢â€š ¬Ã‚ ¦ Lehman Brothers evolved from a general merchandising business to a commodities broker that bought and sold cotton. (4) Lehman Brothers helped fund many major companies that are still around today. Some of these companies include Paramont Pictures, 20th Century Fox, RCA, Haliburton, according to (4). Lehman Brothers kept growing even through the Great Depression, making it one of the largest and strongest financial services firms in the US. Washington Mutual originated in 1889 [as] Washington National Building Loan and Investment Associationà ¢Ã¢â€š ¬Ã‚ ¦ and [lent] its first $700 to build a house in Ballard. (8) Almost twenty years following, the banks name was changed to Washington Mutual Savings Bank. In April 1990, (8) Kelly Killinger was named the companys CEO. Within the next six years, WaMu acquired 16 smaller banks in Washington, Oregon, Utah and California. (8) In the year 1999, [Washington Mutual] buys subprime lender Long Beach Financial, which writes mortgages for people with less-than-stellar credit. This acquisition was a smart move for Washington Mutual to make more money, but it ends up coming back to haunt them in less than ten years. JPMorgan Chase Co. is one of the oldest, largest and best-known financial institutions in the world. (9) JPMorgan Co. started as The Manhattan Company in 1799. (9) JPMorgan Co. merged with many different big name banks and financial institutions of the time. Some of these banks included, Chase Manhattan Bank, Bank One, and The Bank of Manhattan. (9) JPMorgan Co. has also helped numerous big companies start and go public. JPMorgan helped create ATT, GE and U.S. Steel and also helped Apple Computers go public. There are a few different theories of the causes of the financial crisis. One theory is that Freddie Mac, Fannie Mae, and the FHA caused a housing bubble because they were loaning to lower income people that could not afford the mortgage payments after the ARM payments increased over a short period of time. ARM stands for adjustable rate mortgage, which means, when a house is purchased, there is a low interest rate that people like and can easily make the payments. However, the following year, the payment includes a higher interest rate, which is harder to pay, but still manageable. Then a year or so after that, the interest rate increases to an even higher percentage and this payment is too much for the homeowner to make the payment. The high interest on top of the principal made the mortgage payments so high that the number of foreclosures increased at a very rapid rate. Foreclosures are legal [processes] by which a bankà ¢Ã¢â€š ¬Ã‚ ¦takes a homeowners propertyà ¢Ã¢â€š ¬Ã‚ ¦ [And ] is the result of non-payment of the mortgage. (3) Soon after, people owed more money on their house than it was originally worth. This caused a panic in the housing system because homeowners that have had their house for years still owed more than their house was worth. This became a huge problem for investors as well. Some people like to invest in houses and flip them to make a quick profit. Flipping a house is when a house is purchased at a cheap price and is then renovated and sold for a quick profit. These investors were able to buy the house for cheap, but since they were considered dealers instead of brokers, they had an inventory of houses that they could not sell. Having to make mortgage payments on three or four different houses cannot be easy when homeowners are having trouble making one mortgage payment. Many of these investors then had to foreclose on their houses, sending them pretty close, if not, into bankruptcy. Fannie Mae and Freddie Mac were also major contributors to the financial crisis. Fannie Mae and Freddie Mac are government owned companies that were created to securitize mortgages, making the market for secondary mortgages larger. Securitizing mortgages is when a large amount of mortgages are combined into one security so investors only need to invest in one bond instead of hundreds or thousands of separate bonds, leaving more risk on the investor. AAA was, at the time, the safest bond that could be purchased on the bond market. Bonds are debt a company issues for investors to purchase, giving the company more money to operate with. Many investors choose bonds to invest in because they are extremely abundant and some are very low risk investments. Fannie Mae and Freddie Mac were government-owned, so the two most credible credit rating companies rated them as AAA. Freddie Mac and Fannie Mae had been investing in mortgages that were eventually going to overturn; the bonds were not as safe of an investment as investors thought. This had a major impact on the rating system, making it not as trustworthy, influential or reliable as before. The reputation of credit rating companies has since been hard to trust and will remain questionable for a long time. There were now a countless number of foreclosures on the books of Fannie Mae and Freddie Mac. Homeowners were not paying their mortgage payments because they did not have a reason to if they were going to lose their house. Once mortgages started to lose value to investors and homeowners, Fannie Mae and Freddie Mac bonds were not as valuable. This caused a downturn in investments and questionable thoughts about Fannie Mae and Freddie Mac. The second theory for the cause of the financial crisis is that greedy bankers knowingly manipulated the financial system and politicians in Washington [took] advantage of homeowners and mortgage investors. (2) This means that back in 2004 when the exemption was passed, the bankers knew that by having fewer liabilities, they could make more money. So, when banks started being able to invest more money compared to their deposits, they were able to stuff more money back into their pockets, making them even richer than before. This was not good because some people say, money is power and investment bankers did not need more power or money to risk. This extended amount of money was unhealthy because the investment banks could risk more of their money and still have enough capital to cover the bank, if needed. The third and most thought out reason for the financial crisis has ten separate factors, leading to the real answer. (2) According to (2), the ten factors are a broad credit bubble, a sustained housing bubble, excess liquidity, failures in credit-rating and securitization transformed bad mortgages into toxic financial assets, managers amassed enormous concentrations of highly correlated housing risk, risk of contagion, common stock, rapid succession of ten firm failures, and severe contraction in the real economy. The factors listed above are not blaming one person or organization for something they did. These are rational reasons that could have caused the crisis and could have made it easier to calm. However, it is dangerous to conclude that the crisis would have been avoided only if we had regulated everything a lot more, had fewer housing subsidies, and had more responsible bankers. The crisis happened on a much bigger scale than what anyone could have predicted or prevented. The financial crisis of 2008 all started when Christopher Cox, the chairman of the Securities and Exchange Commission, passed an exemption on the regulations for the big five investment banks. The meeting on April 28, 2004 was an urgent plea by the big investment banks. (1) These investment banks were looking for a way to raise their leverage ratio. It is said that at Bear Stearnsà ¢Ã¢â€š ¬Ã‚ ¦ [The leverage ratio] rose sharply, to 33 to 1 (1) shortly after the exemption was passed. The leverage ratio is the ratio between a companys liabilities and common equity. This was a major advantage to Bear Stearns, and the other big investment banks, because they could have a significantly lower amount of their deposits on hand than they were able to before. According to Harvey Goldschmid, a higher leverage ratio means if anything goes bad, it will be an awfully big mess.(1) This statement held true as we see today. On March 16, 2008, Bear Stearns made a deal with JPMorgan Chase Co. (12) This saved Bear Stearns from filing Chapter 11 Bankruptcy. Bear Stearns collapse was only the beginning and nobody could stop the economy from being blind-sided. Bear Stearns spiraled from being healthy to practically insolvent in about 72 hours. This was bad news for the entire economy. Bear Stearns experienced one of the largest bank runs in the history of the U.S. A bank run is when many depositors withdraw their money from a bank in a short period of time because the public does not have any confidence in the banking system as a whole. The public panics because they want to make believe their money will be safer outside of the bank. Bank runs do not occur nearly as often as they did before the FDIC. The Federal Deposit Insurance Company ensures depositors that their money will be safe from bank runs by insuring up to $250,000. A bank run can not only shut down a poorly operated bank but could also shut down a healthy bank. JPMorgan, backed by the New York Fed extended a sure line of credit that [gave] Bear Stearns at least 28 days to shore up its finances orà ¢Ã¢â€š ¬Ã‚ ¦ find a buyer. (12) Bear Stearns was in immediate trouble and people were starting to believe they wouldnt make it out of that one. JPMorgan agreed to pay a mere $2 a share to buy all of Bear [Stearns]. (13) This was a huge discount for JPMorgan because just one year earlier the stock was around $159.36. (14) This was an extreme drop in the price of a once highly valued stock. According to (14), the actual percentage of the price JPMorgan purchased at compared to the 52 week high was a 98.7 percent drop. This was by far the most dramatic drop in stock price in the 21st century, hoping to not be passed up in the near future. Lehman Brothers was a major factor in the financial crisis of 2008, not because the company was the reason of the crisis, but because Lehman Brothers was the largest bankruptcy case in the history of the United States. (6) The bankruptcy was approximately 691 billion dollars in assets. On September 15, 2008, Lehman Brothers Holdings Inc. filedà ¢Ã¢â€š ¬Ã‚ ¦ under chapter 11of the United States Bankruptcy Code.(5) According to the Chapter 11 Bankruptcy form, Lehman Brothers had over 150 billion dollars of bond debt and over 2.5 billion dollars in bank debts. On May 31, 2008, Lehman Brothers had total assets of 639 billion dollars and debts of 613 billion dollars. This is far from what the leverage or debt ratio should be in a major investment bank. Immediately following the Bankruptcy of Lehman Brothers, Washington Mutual collapsed, causing one of the largest banks to also file for chapter 11 bankruptcy. The bankruptcy was preceded by a large amount of withdraws from the bank in a short amount of time. This is called a bank run. According to (7), Washington Mutual had a $16.4 billion dollar run on deposits in as little as a few days. So, after Lehman Brothers went bankrupt, the public started to get a little uneasy because they thought Lehman Brothers was a sound company. This resulted in many depositors of Washington Mutual to withdraw all or most of their funds. Moodys and Standard Poors are credit rating companies that are believed to have had a say in the financial crisis of 2008. Investors are very reliant on credit ratings, especially when it comes to bond investments. When purchasing a bond, there are ratings, which are related to the safety of the bond. An AAA bond rating is considered the safest bond that can be purchased and any bond with a rating of BB or lower is called a junk bond. A junk bond is considered to be a risky investment because it has a higher default risk than AAA bonds. Default risk is the risk that the borrower will not pay either interest or the principle back. For instance, the U.S. government treasury bonds have a lower default risk rate than Greek government treasury bonds. As earlier mentioned, Bear Stearns Co., Lehman Brothers Holding Inc., Washington Mutual, and JPMorgan Co. were major players in the financial crisis. It is hard to choose which theory is correct, but the third theory is the most reasonable because there is never only one factor that goes into changing the economy so drastically.