Research Paper

Published on January 2017 | Categories: Documents | Downloads: 78 | Comments: 0 | Views: 1024
of 19
Download PDF   Embed   Report

Comments

Content

Sanchez1 Jose Sanchez Laura Brandenburg Research Writing October 29, 2010

The 2008 Financial Crisis

Introduction The 2008 American financial crisis is more than just a recession, though this is part of the problem. Recessions,

though never a good thing, are a relatively common, even normal, part of the business cycle (Moffatt “What”). The media defines a recession as a decrease in Gross Domestic Product for two quarters, six months (Moffatt “Recession“). Economists prefer to look at the amount of business activity in the economy by [examining] things like employment, industrial production, real income and wholesale-retail sales. [A recession is] the time when business activity has reached its peak and starts to fall until the time when business activity bottoms out. When the business activity starts to rise

Sanchez2 again it is called an expansionary period. (Moffatt “Recession”) For most people, in past recessions and in the current economic crisis, this is just a matter of semantics. Ronald

Reagan put it very well, in a September 1980 campaign speech, when he said that "Human tragedy, human misery, the crushing of the human spirit . . . They do not need defining—they need action" (Ramirez). The financial crisis of September-November 2008 (or more, as it was ongoing when this paper was written), the “financial meltdown,” was the result of more than just normal economic ups and downs. Oil prices rose greatly, which created economic

pressure, but in the fall of 2008 declined past their starting point in January 2008. Major casual elements of the crisis

include recklessness on the part of the banking and investment industry and a combination of negligence and excessive devotion to free market ideology, on the part of government regulators. The crisis continued in November 2008 because of the lack of real progress in improving the economy. Much of this lack of Problems

progress was caused by the complexity of the problems.

that took years to develop could not be solved in days, or weeks. World stock markets, particularly in the United States, will likely be found to have been both a cause and a result of

Sanchez3 the economic crisis of 2008. Current stock markets no longer

even seem to rise or fall in direct response to particular events (Lepro). Further problems, with the stock market, came from what is best caused a herd mentality that leads investors to sell just because others were selling, even if the others selling are in Japan, Hong Kong and France. The stock market

showed an odd habit of dropping near the end of the trading day, regardless of any objective events that day. analyst tried to explain this by saying, When there is a lot of volatility, especially on a big down day, people just decide they don't want to own stocks overnight," said Ryan Detrick, senior technical strategist at Schaeffer's Investment Research. "News doesn't drive this lower, fear does. Investors will back the next morning after they see where things settled. (Lepro para. 11) The stock market can have psychological effects in addition to straight economic effects. When the markets drop, people One investment

with investments, regardless of their actual situation, feel they have less money to spend, or that it is less safe in the long term to spend money (Lepro). consumer confidence goes down. When they spend less,

Consumer spending makes up 70

percent of the GDP (“Facts on Policy”). When consumers spend less, the economy drops. It is little wonder that the 1929 –

1941 even to which this crisis is being compared, the Great

Sanchez4 Depression, used the same term used in psychology. Before that

event, what we now call a recession was called a “panic.” Fannie Mae and Freddie Mac Two major players in the current financial crisis are the semi-public organizations known as Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Mortgage Association). Fannie Mae was actually formed in 1938, during a

later phase of Franklin Delano Roosevelt’s New Deal, as a government organization, but privatized in 1968. Freddie Mac

was formed as the same type of corporation, private but with government support, in 1970. Both are designed to provide

support to the private mortgage market, but do not make loans themselves. In effect, their very existence has created a

secondary mortgage market, where banks and lenders investment in other banks’ loans. An additional fact that has to be remembered is that Fannie Mae and Freddie Mac, by their special status, are not required to publicly report their financial gains and losses. They are

the only ones of the Fortune 500 not required to file such reports (Alford). The Lobbying Power of Fannie Mae and Freddie Mac Fannie Mae and Freddie Mac maintained their position, until recently, with extensive sophisticated lobbying within Congress and the executive branch of the Federal government. A study of

Sanchez5 this lobbying effort was published just after their September 2008 bailout and partial takeover by the Federal government. The investigation was almost certainly underway before, inspired by reports on of their questionable management and accounting practices (Chaddock). As reported in the study They were the most powerful companies in the country, and literally controlled the Congress," Peter Wallison, a senior fellow at the American Enterprise Institute [said]. "Congress would not do anything they did not want Congress to do – and that came through some very sophisticated political activities and public relations that made it very difficult to challenge them. (Chaddock) Pure cash contribution figures are available for different time periods. extensively. However, they indicate that both companies spent Since 1990, Freddie Mac contributed $9.7 million Since 2004, Fannie Mae contributed $2.9

to Federal campaigns.

million. Together they spent $7.4 million in lobby in the first half of 2008 (Chaddock). This is a period which included both

revelations about questionable accounting, and the mortgage derivative crisis coming to a head. One would not be too

cynical to wonder if both organizations might have done better, for themselves and for the country, by spending money to clean

Sanchez6 up their houses – though with the size of the crisis, $7.4 million would not have made much of a difference. Fannie Mae and Freddie Mac leadership drew from major political figures. The problem here, aside from the obvious

problems arising from the poor results of their management and leadership, is that “When you have leaders who are so well connected and so much of the power structure of Washington, it's not surprising that people would think that these institutions were being well looked after by responsible people," according to a political analyst (Chaddock). A former congressman, and long time critics of Fannie Mae and Freddie Mac, has commented that, ‘Everybody knew people with Fannie and Freddie,’ says former Rep. Jim Leach (R) of Iowa, a longtime critic. ‘More than any financial institution in America, they were dependent upon Congress.’ ‘If Congress ever changed their charter, it could mean billions more or less in profit, depending on how the law is changed. Therefore, Fannie and Freddie had a stable of lobbyists hired in Washington larger than any stable of lobbyists of any enterprise in Washington, times three or four.’ (Chaddock) Federal Bailouts and Takeovers

Sanchez7 At the time of the Federal bailout and takeover, both Fannie Mae and Freddie Mac were ordered to cease all political activities, including lobbying and political contributions. However, the future of their extensive charitable work, which also brought them influence in Congress, remains uncertain (Chaddock). Similar Federal aid, in some form, was extended to AIG Insurance a week or so later. AIG has since been in the news

when, at least twice, senior executives held meetings at expensive resorts. Lehman Brothers, a week after the Fannie and

Freddie take over, was denied such Federal assistance and filed for bankruptcy. The Federal reasoning was that Lehman had too J. P. Morgan, not

many bad assets to make a take over possible.

along after, provided the broker-deal unit of Lehman $138 billion to, basically, settle pending business. The most controversial Federal bailout was a general package proposed in September 2008. The plan, costing over $750

billion, was rejected by the House of Representatives on September 29, 2008, despite its heavy support by President Bush. This caused the Dow Jones to decline over 777 points, the worst decline ever. An adjusted version of the bill passed the Senate After passage in the House it became law on But the

a few days later.

October 3, 2008. No one seemed to really like the bill.

Sanchez8 supporters recognized the dangers of letting the American financial system collapse. Derivatives and SubPrime Mortgages The main cause of the current worldwide economic crisis is the housing mortgage industry, in particular a form of investment known as “mortgage backed securities,” a type of financial instrument known as the “derivative.” Derivatives are

financial instruments whose value depends on an underlying asset (Weinberg). Derivative securities as investments also depend on

the stability and security of the underlying assets backing the derivative. mortgages. A Forbes investment website defines a subprime mortgage as a type of loan granted to individuals with poor credit histories . . .who, as a result of their deficient credit ratings, would not be able to qualify for conventional mortgages. Because subprime borrowers present a higher risk for lenders, subprime mortgages charge interest rates above the prime lending rate. (“What Is a Subprime Mortgage?”) It is an interesting irony that “subprime” is used in its more standard meaning as below normal, rather than to refer to an interest rate below prime. The most common type of subprime mortgage has been the Adjustable Rate Mortgage, ARM. Interest rates start low and In this case the underlying assets are subprime

Sanchez9 then rise. Borrowers had found subprime mortgages easier to

obtain between 2004 and 2006, due to low interest rates, the increased availability of money to lend, and the increased willingness of banks to lend money. The Federal Reserve Board

had been keeping interest rates relatively low, which stimulated borrowing and lending. The Federal government was also encouraging, and forcing, lenders to lend to lower income communities (Brook), with little indication of any control over the lending. Use of money for a

good cause, in the national interest, became reckless distribution of money, definitely not in the national interest. One can also wonder why the government did not realize that a legitimate direct use of government money is to improve living conditions for people. No one has really explained why

investment in low income neighborhoods was not done directly; or at least with more careful government control. ARM rates went up more than many people expected. Lenders

wanted to charge higher rates to compensate them for increased risk. They clearly did not consider that they were increasing the very risk they feared. The number of people forced to default on these loans, and facing foreclosure, substantially increased. Lenders who made these loans directly, or who joined in the process through derivatives, experienced extreme

Sanchez10 financial problems, including bankruptcy (“What Is a Subprime Mortgage?”) The damage to major investment banks was severe. Some

major banks, such as Lehman Brothers and Bear Stearns, went out of business. Fannie Mae and Freddie Mac lost almost $100

billion in stockholder share value in 2008 alone, as of the end of August 2008. (Bogoslaw). Overreaction to the overextending of credit led to a substantial and equally damaging tightening of credit. almost briefly disappeared. Credit Stock price for both was down about 85%

The results in the economy and

American and world stock markets in the fall of 2008 were drastic. Warning Signs Looking back at how the crisis of 2008 began, one cannot help wondering how and why it was allowed to happen. Warnings

signs about derivatives and subprime mortgages were available several years before 2008. In the Berkshire Hathaway Annual

Report for 2002, noted investor Warren Buffett, one of the richest and most successful men in the world, described derivatives as “time bombs, both for the parties that deal in them and the economic system” and announced that his company was getting out of derivatives (Berkshire Hathaway 13).

Sanchez11 About the same time, in an attempt to justify the need for limited or no Federal government regulation of derivatives, then Chairman of the Federal Reserve Board Alan Greenspan, stated that, Although the benefits and costs of derivatives remain the subject of spirited debate, the performance of the economy and the financial system in recent years suggests that those benefits have materially exceeded the costs. Except where market discipline is undermined by moral hazard, owing, for example, to federal guarantees of private debt, private regulation generally is far better at constraining excessive risk-taking than is government regulation. (Weinberg) Greenspan has been a major proponent of deregulation. also was the leading proponent, through the Federal Reserve Board’s power to set interest rates, of lower rates. Greenspan testified before the United States House of Representatives, Committee on Oversight and Government Reform, in late October 2008 that . . . those of us who looked to the self-interest if lending institutions to protect shareholder’s [sic] equity (myself included) are in a state of shocked disbelief. Such counterparty surveillance is a central pillar of our He

Sanchez12 financial markets’ state of balance. If it fails, as

occurred this year, financial stability is undermined. (2) Conclusions As quoted above, Alan Greenspan recently stated that, . . . those of us who looked to the self-interest if lending institutions to protect shareholder’s [sic] equity (myself included) are in a state of shocked disbelief. Such counterparty survellience is a central pillar of our financial markets’ state of balance. If it fails, as

occurred this year, financial stability is undermined. (2) Greenspan accurately gave reasons for the current crisis, why a possibly inevitable economic slowdown has been described as the worst crisis since the Great Depression of the 1930s. The financial industry saw a way to make a lot of money, using great availability of credit to lend money to people who might otherwise not be able to get loans to buy houses. Increasing the number of families who own home is in keeping with the proverbial American dream. But they forgot

that part of the American dream is earning one’s own way. Helping neighbors who need help is also in keeping with American traditions, but long term help is supposed to go where it can do the most good. And it is supposed to be real, and accomplish

something, not set people up, however well meaning the help, for more drastic future failure.

Sanchez13 Investing in home mortgage loans, through derivatives, was in keeping with the general bank practice of sharing the risk by trading or selling loans. Investments can rarely be guaranteed. Investors

However, there is a concept called “due diligence.”

are supposed to check on the reasonable safety of the risk they are taking. Mortgage lenders, and derivative buyers, including

Fannie Mae and Freddie Mac, did not perform due diligence. Housing is a proper area of government interest, and for this reason alone the Federal government should have become involved. If the Federal government did not want to directly

invest, it should have paid more attention to the investments that were being made. The Federal government should have If these loans

noticed the increase in potentially risky loans.

were felt to be in the national interest, the government at least would have been prepared for increased loan defaults. When a second step was added, through derivatives, the Federal government should have realized the potential negative multiplier effect of defaults if people could not meet their mortgages. Greenspan held an office, Chairman of the Federal

Reserve Board, where he particularly should have realized the potential problems. But Alan Greenspan, who was by no means alone, was too strong an advocate of deregulation. He represented the

ideological view that failed to realize that a totally

Sanchez14 unrestrained free market runs the risk of recklessness, and that it can be as bad as a totally controlled market. This view

allowed Fannie Mae and Freddie Mac to operate as loose cannon hybrids, neither fully private sector nor fully government agencies. Greenspan, in October 2008 became on the few public Mistakes are not made. People make

officials to admit error. mistakes.

The general Federal bailout to the financial industry, passed at the end of September 2008, was very controversial. Arguments against the bailout were valid, stating that part of the free market is the ability to fail and go out of business. Companies should not be rewarded for poor management, poor judgment or out and out greed. Arguments in favor tended to

admit that argument as being true, but that the rippling damage from further financial institutional failures would be far worse. The government had to be seen to be doing something. One

hopes the government will take correct action, but the action itself is often sufficient. Franklin Delano Roosevelt Herbert Hoover, his

recognized this truth, as far back as 1933.

predecessor, had responded to the Great Depression by doing nothing. When unemployed World War One veterans camped in the

outskirts of Washington, D.C., Hoover sent army troops to remove them. Roosevelt tried to show the American people that he cared

Sanchez15 about them, and that his administration was acting to solve the economic crisis. He also tried to show the people that he cared

what they think, and that he recognized the need to “sell” his programs and policies to the American voters. President Ronald Reagan was called the “great communicator,” because of his ability to talk directly to the American people to win support for his programs, and because he realized the value of doing going to the people. the first great communicator. Roosevelt was

He held his first “fireside Roosevelt used He assured the

chats” over national radio on March 12, 1933. simple language to explain the banking bill.

American people that it was "safer to keep your money in a reopened bank than under your mattress" (Roosevelt 64). Roosevelt continued to effectively use radio throughout his administration. The Bush Administration in its remaining months, and the Obama administration, have to be shown to be acting in order to restore confidence in the American and world economic systems. The government has to be shown to be doing something, to restore confidence in the system. The government has to judge

policies on what is likely to work, in the short and the long term, not based on the ideology. Ideology has not worked in the

past, most damagingly the lax financial regulations of the past few years. The October and November volatility in the stock

Sanchez16 markets, with the slow implementation of the Federal bailout package, as well as general lack of investor confidence, showed

that those favoring the plan had at least this fact correct. If there is a lesson to this whole crisis, it is that government regulations and controls are most effective as a last resort. Free market advocates have this right. However, the

major financial sector error of the past few years is forgetting that government controls and regulations have a purpose, if only as a threat to combine with incentives as the best way to ensure good behavior. Government controls may not have to be used.

But they have to remain ready and be seen to remain available.

Sanchez17 Works Cited Alford, Rob. “What Are the Origins of Freddie Mac and Fannie Mae?” History News Network. 2003 and 2008. George Mason

U. 17 Nov. 2008 <http://hnn.us/articles/1849.html>. Berkshire Hathaway 2002 Annual Report. 2003. 16 Nov. 2008 <http://www.berkshirehathaway.com/2002ar/2002ar.pdf>. Bogoslaw, David. “Fannie Mae and Freddie Mac: A Damage Report.” 29 Aug. 2008. Business Week. 17 Nov. 2008

<http://www.businessweek.com/investor/content/aug2008/pi200 80828_330540.htm>. Brook, Yaron. “The Government Did It.” Forbes. 18 July 2008. 17

Nov. 2008 <http://www.forbes.com/2008/07/18/fannie-freddieregulation-oped-cx_yb_0718brook_print.html>. Chaddock, Gail Russell. “Fannie Mae, Freddie Mac wielded big clout in Washington.” 12 Sept. 2008 Monitor. 17 Nov. 2008 <http://www.csmonitor.com/2008/0912/p03s01-usec.html>. “Facts on Policy: Consumer Spending.” Hoover Institution. 19 Dec. 2006. 16 Nov. 2008 <http://www.hoover.org/research/factsonpolicy/facts/4931661 .html>. Greenspan, Alan. “Alan Greenspan, Committee on Government Oversight and Reform.” 23 Oct. 2008. 16 Nov. 2008 Christian Science

<http://oversight.house.gov/documents/20081023100438.pdf>.

Sanchez18 Lepro, Sara. “Stocks Skid on News Gov’t Won’t Buy Banks’ Assets.” Yahoo! News. 12 Nov. 2008. Yahoo! 12 Nov. 2008 <http://news.yahoo.com/s/ap/20081112/ap_on_bi_st_ma_re/wall _street>. Moffatt, Mike. “What Is the Business Cycle?” About.com. 2008. The New York Times Company. 16 Nov. 2008.

<http://economics.about.com/cs/studentresources/f/business_ cycle.htm>. ---. “Recession? Depression? What's the Difference?” About.com. 2008. The New York Times Company. 16 Nov. 2008 <http://economics.about.com/cs/businesscycles/a/depressions _2.htm>. Public Papers and Addresses of Franklin D. Roosevelt, Volume Two: The Year of Crisis, 1933. New York: Random House, 1938. Ramirez, Jessica. “The Difference between a Recession and a Depression.” Newsweek. 16 Oct. 2008. 16 Nov. 2008

<http://www.newsweek.com/id/164211>. Weinberg, Ari. “The Great Derivatives Smackdown.” 2003. 13 Nov. 2008 <http://www.forbes.com/2003/05/09/cx_aw_0509derivatives.html >. What Is A Subprime Mortgage?” Investopedia: A Forbes Digital Company.2008. 17 Nov. 2008 Forbes. 9 May

Sanchez19 <http://www.investopedia.com/ask/answers/07/subprimemortgage.asp>.

Sponsor Documents

Or use your account on DocShare.tips

Hide

Forgot your password?

Or register your new account on DocShare.tips

Hide

Lost your password? Please enter your email address. You will receive a link to create a new password.

Back to log-in

Close