Question

The Financial Crisis

11. What event is viewed to have tipped the situation from a troubled housing

market to a full-blown financial crisis in 2008?

12.How would the economy overall have been affected by significant bank failures?

13. What did the Fed do to intervene?

14. What was TARP?

15. Why does a financial crisis almost always lead to an economic downturn?

Answer 1

11. The bankruptcy filing of Lehmann Brothers. That was the tipping point which changed the whole equation from a troubled housing market to a full blown financial crisis in 2008. The fourth largest investment bank at that time, when it filed for Bankruptcy, there was panic in the market. This panic led to a raid and panic selling of securities which were till then in high demand. This led to fall in asset price which backed the securities eventually starting the downfall of the market.

However, it was not a single event which started the downfall. The Lehmann Brothers Bankruptcy was followed soon after by 3 more events

1. The AIG Collapse which happened on the 16^th of September 2008
2. The flee of the investors from the Money Market: Investors took out money from the Money Market to protect their capital when they saw that the reserve primary fund was invested in Lehmann Brothers. There was a panic that the fund could not pay back the money to the investors as Lehmann brothers declared bankruptcy. This led to a drastic loss of liquidity of the entire US Economy
3. The difficulty in getting an approval for the TARP or Troubled Assets Relief Plan soon after

12. As Lehmann Brothers declared bankruptcy, there was panic in the market. Various types of investors tried to retrieve their money which they had invested in various instruments. The most ppular and largest was the Reserve Primary Fund which was a money market mutual fund. This was a low yielding and extremely safe mutual fund. To get a high yield, this RPF had $785 million of Lehmann Paper. With the bankruptcy filing, the fund started to lose value. As more and more investors tried to withdraw their money, the fund couldn’t return the money to all thus losing almost 90% of its value. The total assets of money markets fell drastically. As the assets fell, the bank funding dried up as these mutual fund took the money from the investors and bought bank commercial paper. With fall of bank funding, credit disappeared overnight and there was extreme pressure on the economy.

13. The Fed did a major goof up in trying to intervene. The credit taken by the home owers was insured by AIG who felt that the home owners wouldn’t default. However, as defaults started, AIG was faced with insurmountable claims. AIG had over $400 million in credit default swaps which meant that in case there is any default in repayment, AIG would have to pay up. As these payments loomed large, short term funding very quickly dried up for AIG. Since this was a too big to fail institution, The Fed steped in with loans of $85 billion just to keep AIG afloat.

This resulted in other institutions taking advantage of The Fed bailing them out in case of difficulties thus causing pressure on the Fed and eventually the US Government and the US Economy.

14. TARP or Troubled Asset Relief Program was a document introduced which gave an authority to the US Treasury to bypass the Congress and spend upto $700 billion to purchase subprime mortgage assets from different financial institutions which were in trouble. This would help to bring about liquidity in the banking system. Though the Congress initially voted down the bill, it was later passed with different tax breaks.

15.

A financial crisis leads to panic among small investors who feel that they will lose money. So they start pulling out funds that they have invested. As a result, the asset values goes on falling. This leads to more investors panicking when they see the value of their investments falling. There is a huge pull of funds from the market to the individual investors. When the institutions cannot service hese investors, they have to declare bankruptcy. As more and more smaller institutions or a few large institutions declare bankruptcy and liquidity disappears from the system in the blink of an eye, it is difficult to even get groceries on the shelf of stores. Also, this leads to calculated spending and thus lower earnings. All these combine to go on in a vicious cycle leading to economic downturn.