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Financial Crisis

This is a menu of the topics on this page (click on any): The subprime mortgage crisis    Fannie Mae & Freddie Mac    The Crisis in Broker-Dealers    AIG    The savings and loan crisis   .

The financial crises we are repeatedly facing are inevitable results from the following:
  1. When you can borrow money at low rates and lend money at high rates you can make a lot of money; that's called arbitrage.
  2. If your borrowing is short term and your lending is long term, you might find yourself in the sad position of having depositers asking for their money but you've invested it in long term assets like real estate which are not liquid. When word gets out that you cannot repay deposits you get a "run on the bank". That's a dreadful crisis for which the fed is likely to make rescue.
  3. The compensation of business managers at all levels is heavily weighted to short term results. That means one can do very well when short term opportunities are good even though long term prospects are risky. It is up to stockholders and to regulators to make sure that this does not put financial businesses at risk.
  4. Business enterprise is a useful way to organize human beings for getting things done. But, this sure does focus a spotlight on the importance of business oversight and regulation.
  5. Whoever it is that says an unrestrained free market is golden is very foolish. Each of these financial crises has been preceeded by a time of giddy excess. Tom Blackburn put it well in his Palm Beach Post editorial of 9/15/08 with the simple phrase "private profits and public losses". Many writers are pointing out that if we are going to bail out business when it fails we need to regulate it to reduce the likelihood of failure. Business is often tempted to enjoy short term success without adequately seeing long term or public risk.

The subprime mortgage crisis

The subprime mortgage crisis is a current economic problem characterized by contracted liquidity in the global credit markets and banking system. An undervaluation of real risk in the subprime market cascaded, rippled and ultimately adversely affected the world economy.

The crisis began with the bursting of the US housing bubble and high default rates on "subprime" and adjustable rate mortgages (ARM). Loan incentives, such as easy initial terms, in conjunction with an acceleration in rising housing prices encouraged borrowers to assume difficult mortgages on the belief they would be able to quickly refinance at more favorable terms. However, once housing prices started to drop moderately in 2006-2007 in many parts of the U.S., refinancing became more difficult. Defaults and foreclosure activity increased dramatically, as easy initial terms expired, home prices failed to go up as anticipated, and ARM interest rates reset higher. Foreclosures accelerated in the United States in late 2006 and triggered a global financial crisis through 2007 and 2008. During 2007, nearly 1.3 million U.S. housing properties were subject to foreclosure activity, up 79% from 2006.

The mortgage lenders that retained credit risk (the risk of payment default) were the first to be affected, as borrowers became unable or unwilling to make payments. Major banks and other financial institutions around the world have reported losses of approximately U.S. $435 billion as of 17 July 2008. Owing to a form of financial engineering called securitization, many mortgage lenders had passed the rights to the mortgage payments and related credit/default risk to third-party investors via mortgage-backed securities (MBS) and collateralized debt obligations (CDO). Corporate, individual and institutional investors holding MBS or CDO faced significant losses, as the value of the underlying mortgage assets declined. Stock markets in many countries declined significantly.

The widespread dispersion of credit risk and the unclear effect on financial institutions caused reduced lending activity and increased spreads on higher interest rates. Similarly, the ability of corporations to obtain funds through the issuance of commercial paper was affected. This aspect of the crisis is consistent with a credit crunch. The liquidity concerns drove central banks around the world to take action to provide funds to member banks to encourage lending to worthy borrowers and to restore faith in the commercial paper markets.
The above text was excerpted from Wikipedia:Subprime mortgage crisis

Fannie Mae & Freddie Mac

We appear headed for a $400 billion buyout. Slate.com argues that $400 billion is a bargain for the public benefit that has been derived from the knowledge that the feds would provide a rescue if it were ever needed.

The Crisis in Broker-Dealers

We have five big securities broker-dealers: Bear Sterns, Lehman Brothers, Merrill Lynch, Goldman Sachs, and Morgan Stanley. Bear Sterns was "rescued" by the fed last week, Lehman Brothers was abandoned last week, and Merrill Lynch is now being rescued with its purchase by Bank of America. Goldman Sachs and Morgan Stanley and many smaller firms await their fate. The best prospect for most will be to sell themselves to a commercial bank as Merrill Lynch and A.G.Edwards have done (to Bank of America and Wachovia respectively).
See "Brokers on Borrowed Time".

AIG

A.I.G. is seeking a $40 billion in federal aid to survive.

The savings and loan crisis

The savings and loan crisis of the 1980s and 1990s was the failure of 747 savings and loan associations (S&Ls) in the United States. The ultimate cost of the crisis is estimated to have totaled around $160.1 billion, about $124.6 billion of which was directly paid for by the U.S. government, that is, the U.S. taxpayer, either directly or through charges on their savings and loan accounts which contributed to the large budget deficits of the early 1990s. The simple explanation of how this crisis came about is that the S&L business model was that it borrowed short and loaned long. That means that it made money because it had assets in demand deposits that were paying modest rates and it invested those funds in long term assets (mostly real estate) that paid higher rates but which were not liquid. When depositers asked for their money back the S&L's were not able to repay because they had invested the funds in assets that were not easily liquidated. During the giddy S&L days managers were paid big bonuses for bringing in short term deposits at low rates while their business partners made real estate loans at higher rates. When short term rates became higher than long term rates S&L's lost money. The federal government chose to bail out the S&L's rather than have citizens go to the bank and not be able to get their money back.
Savings and Loan crisis

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