Question

we have encountered several firms that have either failed or came close to collapsing during the Financial Crisis of 2007-2009 (e.g., Bear Stearns, Lehman, AIG, Fannie Mae…).

Select one of these firms and write ：

1. Describe in some detail the events that led to the failure of the firm. What went wrong?
2. Describe the interconnectedness of the firm, and how that may have played a role in the US government’s response to its pending failure.

Answer 1

Q. Describe in some detail the events that led to the failure of the firm. What went wrong?

1. Sub - Prime Crisis

The most primary or the root cause to the financial crisis was 'Pursuing Greed without acting within defined regulations'. The fall of these behemoths is due to their own wrong doings. To capitalize on peoples dream to have more money, these financial institution like investment banks, insurance companies, companies with funds to deploy brought destructive instruments like Collateral debt obligations, mortgage backed securities, etc. In simplest words, these institutions relaxed the norms of providing loans, this had risk of default on the head of the institution. They invented new ways of channelizing these risk from their head to others by providing rousy picture and bullish scenarios. Institutions like rating agencies were given their share to conceal real facts and give good ratings to securities offered to public and other institutions. This was supported by the boom phase of the economic cycle however the plummet in the market did worse to all institutions as they all were not only connected internally but internationally in various countries as well. extreme speculations and non adherence to regulations costed many institutions to shut down like Lehman Brothers, Merrill Lynch.

2. Increased Securitization

The financial crisis, 2008 is known for invention of many new financial instruments. One of them is securitization where mortgages were collectively brought together to form mortgage backed security that can move the burden of debt from the companies to other participants of the market thereby spreading the risk to other players. These mortgage backed securities were backed by credit default swaps.

3. Reckless Lending across Financial Institutions

Financial institutions started lending money to people for various reasons. this was not only in USA but also in Europe. a person could get a loan to purchase a private jet, penthouse and so much more. However the capacity to payback the obligation by the borrower was neglected. This was a primary move by the banks to increase their book size in their financial statements.

4. The 'responsible' Institutions did not act responsibly

It was found that many organisation whose responsibility was to oversee the functioning, auditing and rating did not do their job. Companies like KPMG was held for giving clean chit to banks that gave loans without abiding to a proper credit policy regulations. Companies like American International Group which was a safest giant in terms of insurance, started to use the money from its insurance policy to vest their time and money in sale.

5. Intervention by House Buyers

Everyone became bullish about properties but few had known that this rising value of houses was a fad that would plummet. The house were available to buyers much easily due to financing options. The home buyers came in pouring to buy houses, in case of the downside, if the home buyers were not able to pay the amount of loan and interest they would the house. But nobody took into consideration that if the price of the house goes down, the banks would never recover their money. To add to this existing problem, easy lending policies made the present home owners use their homes as collateral to purchase another. surge in purchases of new homes led to the increase in the value of homes to the extent nobody could afford from this point onward the housing bubble burst.

6. Policies supporting the financial sector

Companies like Fannie Mae were nearly Government backed institutions. They were allowed to have a liquid secondary market. This means that companies like Freddie mac an Fannie Mae can trade their mortgages in the market. This freed the institution only to transfer the risk to a large number or mortgage buyers. Despite continuous reminders from various economists, people like Alan Greenspan not only showcased this adverse situation as normal situation but also allowed these activities.