Financial Markets and Institutions

Question 1

The financial crisis has come in the year 2007-2008 with the effect of the housing bubble which means frequent changes in the prices of assets class such as houses, stock or other commodities, etc. that exceeds its intrinsic value. Let us discuss the causes which would have had the biggest impact in the United States economy.

The first cause was Federal Reserve (Fed) the central bank of the United States was started in 2001 that reduced the interest rate from 6.50 % in May 2000 to 1.75 % in December 2001 (Duignan, 2019). By decreasing the interest rate it allows the bank to extend consumer credit at the lowest rate. As a result, customers take advantage of cheap credit to buy durable goods – electronic appliances, houses, cars, etc. which would result in a housing bubble.

The second cause was changing in the banking laws. At the beginning of 1980s banks offer subprime mortgage loans with balloon payments that means large payments due at the end of the period or the interest rate is usually low in the starting period (Chomsisengphet & Pennington-Cross, 2006). A subprime mortgage is a type of loan which is issued to borrowers with low credit ratings having a high rate of interest for compensating their additional risk and involves high credit risk.

When the home price tends to increase it would result in the subprime borrowers protecting themselves against high mortgage payments or by selling their homes at a high profit so that they will pay their mortgage amount. In case of default, banks have the right to sell the property of the borrower at higher prices above the original amount which was shown in the sanction letter. Due to this, many banks intentionally offer subprime loans to customers with poor credit facilities as they already know that they could not repay the loan amount. Due to this, the share increased from 2.5% in 1990 to 15% in 2007 (Duignan, 2019).

The third cause was related to securitization. As banks combined hundreds or even thousands of subprime mortgages and sold them in capital markets – bonds, hedge funds, pension funds, etc. where Bonds mean Mortgage-backed securities. Selling subprime mortgage as Mortgage-backed securities was a good way to increase their liquidity, stability in the market, and reduce their risky loans. While purchasing MBS, it is a good source for the banks to earn money by diversifying their portfolios (Chomsisengphet & Pennington-Cross, 2006).

The fourth cause came with a concept too big to fail as its failure threatened the entire financial system. In 2004 the SEC (Securities and Exchange Commission) decrease the net capital which totally impacts the total assets and total liabilities. It is treated as a safeguard for banks which encouraged them to invest more money into MBS.

The fifth and the last one started in the 1980s, which is known as Great Moderation, which satisfied many financial institution and the U.S government.

The federal fund rate was increased from 1.25% in June’2004 to 5.25% in June’2006 (Duignan, 2019) which resulted in more default in the loan amount. Due to many subprime mortgage loans, customers protect themselves by selling, refinancing or borrowing their homes because many mortgage holders owed more on their loan amount than their home value. Due to so many defaults, it damaged the image of financial institutions, banks, etc. and caused huge losses.

It was difficult to predict the strength of bank MBS as assets and the securities were downgraded by credit rating agencies which were treated as worthless assets.

It is the worst economic recession as it destroyed the overall international financial systems like insurance companies, banks, financial institutions, etc.

To solve this serious problem the US Congress took a big step by making a secondary market for promoting home ownership so that it would become easier to borrow money for buying of houses. For this, it took the help of two government sponsor enterprise namely Freddie Mac & Fannie Mae as they provided liquidity, stability, and affordability to the mortgage market

In April 2007, one of the biggest subprime lenders filed for bankruptcy due to which many other subprime lenders ceased their operations.

The Federal Reserve helps to purchase federal funds at the lowest rate with more liquidity. In January 2008, Bank of America purchased Country Wide Financial for $4 billion in stock (Duignan, 2019). In March 2008, Bear Stearns finished its liquid assets and was purchased by JP Morgan Chase.

In 2008, Fannie Mae (the Federal National Mortgage Association) and Freddie Mac (the Federal Home loan Mortgage Corporation) influenced the secondary mortgage market which involved buying and selling of mortgage loans. The main reason behind their establishment is to provide liquidity either by selling or buying them with a guarantee of principal and interest payment. At the beginning of 2000, the share of a subprime mortgage increased due to policy changes. This will impact awareness of homeownership among low income and minority groups. It became riskier because their liabilities were huge and the chances of default in loans were high. To recover from this crisis, the United States Treasury Department freed both corporations by replacing their directors and by giving the security to cover their debts which amounted to approx. $1.6 trillion (Duignan, 2019). After one month Lehman Brothers which was a 168-years-old investment bank filed the largest bankruptcy amounting $639 billion assets (Duignan, 2019).

The Federal Reserve gave a loan amounting $85 billion (Duignan, 2019) to American International Group (AIG) to cover losses in the sale of credit default swaps (CDS) which is a contract which protects debt holders including MBS.

For protecting the financial system of the United States economy Emergency Economic Stabilization Act (ESSA) was established under which Troubled Asset Relief Program (TARP). It was introduced with the help of Treasury Secretary Henry Paulson, who gave permission from United States Banks to invest $700 billion (Duignan, 2019) in MBS.

As government purchased, MBS did not provide sufficient liquidity, so Paulson authorized to use $250 billion (Duignan, 2019) in TARP funds to purchase preferred stock. After taking Quantitative Easing (QT) measures it improved the liquidity and stimulated economic growth.

In February 2009, after the adverse effect of the Great Recession, $787 billion (Duignan, 2019) program was introduced by Barack Obama. This resulted in tremendous growth in the economy after two years of the deep recession.

The net worth of American Household has declined by approx. $17 trillion (Duignan, 2019) in the year 2012 estimated by St. Louis Federal Reserve Bank. According to the Federal Reserve Bank of San Francisco, the country gross domestic product was approximately 7% (Duignan, 2019) lower than the rate before the crisis. The unemployment rate was 10% (Duignan, 2019) between 2007 and 2009 as 7.5 million jobs were lost. In 2018, the unemployment rate reduced to (Duignan, 2019) 3.9% which constitutes remarkable growth. This financial crisis affected the overall economy as millions of families lost their homes and millions of workers lost their jobs and eventually faced long term unemployment and as a result, a great number of people fell below the poverty line.

Question 2

Question 3

Winners and Losers in the 2008 Financial Crisis

The 2008 Financial crisis had a deep impact on all Americans. Impact had been so huge that more than 8 million jobs were lost, there were double-digit drop-in housing values, Dow Jones industrial average plunged drastically. But there were select few who were untouched. Those who were hardest hit were the middle class, recent college graduates, pre-retirees and home owners.

Winners and Losers of the Great Recession

The wealthy can be put in winners’ category – If true winners can be found in any recession, the wealthy certainly qualify in the Great Recession, this is because they had a diversified portfolio of assets which the middle class didn’t. Alternative investments apart from financial products were safe. The middle-class assets were primarily concentrated in homes. The wealthy did not experience any job loss, but the middleclass did experience job losses which went as high as 15.3% from 7.7% (Tasci, 2011).

The middle class can be put in the losers’ category – The middle class continued to take a beating from the recession and the share of working families who were low income had risen to 10.2 million. Home buyers also qualifies for the loser’s category as the Housing bubble burst had provided homebuyers opportunity to get deals of a lifetime. According to the NAR's Housing Affordability Index, the median price of a single-family home dropped from $196,600 in 2008 to $168,400 in August 2011 (MacDonald, 2012). During that same period, median mortgage rates declined from 6.15% to 4.69%, and the money you would need to buy the average home dropped nearly 25% from $45,984 to $33,504.

Home sellers can be pit in loser’s category – According to NAR figures, median home sale prices across the country fell from $196,600 in 2008 to $173,100 in 2010. Homes put up for sale were fetching even lesser prices thereby incurring losses to sellers (Cerone, 2011).

Question 4

Part II

Question #1

The Federal Reserve has taken action aggressively towards the financial crisis that emerged in 2010. The reserve implemented designed programs in order to support the liquidity of financial institutions and be able to improve the conditions in the financial market So far its been successful and has improves little by little the reserves balance sheets.

Even though the there has been programs that have expired or have closed out the government still goes ahead and continues to contribute new implementations of programs and take the actions needed in order to setup a stable market after all. Some of the actions that these programs involved over the few amount yeas prior have been long-term securities putting downward pressure on the long term interest rates that have been caused by the crisis.

One of the tools they used was to provision liquidity directly to borrowers investors in the key credit markets. Another tool used has been provisioning short-term liquidity to banks and other institutions. And lastly one of the many tools but one of the top three tools they have used is expansion of the open market in order to support the function of credit markets and out downward pressure on the long-term interest rates and be able to assist those with longer-term securities.

Currency swap agreements were also implemented to help those institutions tied to central banks. This was going to provision the dollar liquidity to banks in there jurisdictions. This was due to the market being in a global level.

In 2011, the European central bank begun to purchase government bonds to keep the yields from reaching level that countries, such as Italy and Spain could not afford. This was going to benefit those banks that were troubled initially and would assist them directly with really low rates. This program was called the Long Term Refinancing Operation (LTRO).

In 2012, the European central bank President has announced that they would be doing whatever it took in order to keep the crisis stable. This was something that repeatedly cut the interest’s rates out and offset deflationary effects. This continued to purchase government bonds at a rate of $100 bn euros per month. This program is really similar to what was used in the U.S Federal Reserve. The goal is to inject money directly into the economy through large scales of purchase of government bonds.

Today, these are the actions that have lead to slow economic growth. However the crisis is over

Question #2

Question #3

Question #4

References