Cause of Problems for Financial Institutions During the Credit Crisis

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While the mortgage market went downhill, investors didn’t realize that issues associated with the mortgage market would also affect the stability of the debt market. With all these financial defaults, the overall stability of collateralized debt obligations was affected as well. These debts were split between different funds from people all around the world. The investors did not receive payments as they expected.

Credit Default Swaps is risk transfer of credit risk exposure to secure debt. A transfer of risk from a financial entity to an outside party which becomes a legal contract put in place from the purchaser to the issuer. A fee is paid to the financial entity that is responsible to cover the potential losses to the party who purchased the credit default swap. Basically acts of insurance, paying fees in case of a risk catastrophe. Credit Default Swaps were sold as insurance against the default of mortgage backed securities.

American International Group for example sold billions of dollars’ worth of these insurance policies without money to back them up in default situations. These defaults were also turned into other securities that allowed traders to bet huge amounts of money based on if the value of mortgage securities would go up or down. These financial instruments consisted of assets, liabilities, and risk that went bad for the entire financial system causing bankruptcy like Lehman Brothers, others were forced into mergers, or needed government bail outs. Trading and credit market froze, the stock market crashed and the U.S. economy found it’s self in a disastrous recession by 2007.

The Lehman Brothers suffered a huge downfall during this crisis. It was became known as the biggest bankruptcy in history. Lehman Brothers Holdings Incorporated was a global financial services firm, the 4th largest investment bank doing business in investment banking, equity, and private banking and many other lines of financial business. When they filed for bankruptcy, it was found that Brothers hid over $50 billion dollars in debt and $60 billion dollars in real estate holdings. This resulted in an overstatement of cash assets which improved financial position of the company. Due to this collapse of misrepresenting assets, millions of investors lost their money. Many other financial institutions that failed were Goldman and Sachs, Merrill Lynch, and Citigroup. A total of 369 billion were taken off the value of financial firms in the market.

Bear Stearns, the fifth largest investment company was sold to JP Morgan Chase at $2.00 per share. They were a major investor in the mortgage backed security market. The problem during the crisis is that they were not diversified as compared to other banks in the business. As with all banks, Bear Stearns wanted to leverage their credibility, borrow money of short term interest rates, and buy long term debt with high interest and earn the difference between the two interest rates. When a bank loses its credibility, it will not be able to borrow short term interest rates anymore. “They were nearly out of cash. Faced with a slew of withdrawals from worried clients and a sudden pullback from lenders, the firm had less than $3 billion on hand” (Kelly).

In response to the economic crisis, the Federal Reserve stepped in and provided emergency loans to banks better known as Bank bailouts for asset relief. Congress passed stimulus packages that circulated over $800 billion into the economy through new spending and tax cuts. This allowed people to spend again. Many businesses profits were low and needed to be increased again. So this money put into the economy was much needed. New forms of regulation were put into place so that bank requirements for home purchases are not easily obtained anymore. Home prices are still drastically lower than the last mortgage loans obtained and the values are still down. Banks have no choice but to abide by the new rules and regulations in place when lending to borrowers.

As you will see, everyone was affected during the credit crisis. People not only lost their homes, they also lost jobs due to this economic hardship. To sum it all up, the problem was caused mainly from the frozen credit markets. Deflation occurred as when prices drop, businesses cut cost, laying off workers that can’t buy anything, while inventory builds up leaving more and more workers unable to purchase goods and services that would keep these businesses open. It appears the banks can take the head of the blame. The banks knew they would be bailed out by the government so it seems that they took this excessive risk with that in mind. The risks and the capacity of these risks were unacceptable. Everyone in the financial system was borrowing too much money and taking on too much risk. Even home owners taking on these mortgage loans when they knew they couldn’t afford them.

Work Cited

Amadeo, Kimberly. "Credit Default Swaps: Definition, Pros, Cons, Crises." The Balance, www.thebalance.com/credit-default-swaps-pros-cons-crises-examples-3305920.

Bajaj, Vikas. “Freddie Mac Tightens Standards – The New York Times. “The New York Times – Breaking News, World News & Multimedia, www.nytimes.com2007/02/28/business/28mortgage.html?_r=0

Beattie, Andrew. "Market Crashes: Housing Bubble and Credit Crisis (2007-2009)."Investopedia, www.investopedia.com/features/crashes/crashes9.asp.

"The Case against Lehman Brothers - CBS News." CBS News - Breaking News, U.S., World, Business, Entertainment & Video, www.cbsnews.com/news/the-case-against-lehman-brothers-23-04-2012/.

Kelly, Kate. "Inside the Fall of Bear Stearns." WSJ, 9 May 2009, www.wsj.com/articles/SB124182740622102431.

Petroff, Eric. "Who Is To Blame For The Subprime Crisis?" Investopedia, www.investopedia.com/articles/07/subprime-blame.asp.

Singh, Manoj. "The 2007-08 Financial Crisis in Review." Investopedia, www.investopedia.com/articles/economics/09/financial-crisis-review.asp.

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