Bear Stearns, a financial company and global investment, collapsed because it had high-risk toxic assets. The cash reserves declined, and the company lost the confidence of its customers (Kirk, 2009). Investors, being afraid of losing money, wanted to sell stocks, which resulted in their massive drop. Bear had only around $3 billion, which was not enough to open the bank’s doors for its customers.
A subprime mortgage is lent to the borrower who has a low credit rating. The interest rate for it is higher to compensate the lender for the risk. The subprime mortgage is referred to as a toxic asset because it was offered in large numbers to unqualified borrowers that led to the defaults (Kirk, 2009). Thus, two things that make subprime mortgages are high-interest rates and high risk.
A credit default swap (CDS) is a business derivative that allows the lender to swap his or her credit risk with another investor in case the borrower defaults. To do so, the lender buys the CDS from the investor who agrees to compensate for the loss. CDS requires payments to maintain the agreement, which serves as an insurance policy. The AIG company sold its CDSs to Lehman Brothers when those went bankrupt. But they did not have enough resources to pay back all the people they sold CDSs to (Kirk, 2009).
The Federal Reserve Bank (FRB) extended credit for Bear Stearns through JPMC Bank. This unusual act allowed Bear Stearns to meet its obligations and search for options during the weekend that could help the bank avoid bankruptcy (Kirk, 2009). The FRB did not receive any warrant in exchange for the bridge loan, but the borrower repaid in full. Moreover, the FRB extended the loan to the limited liability company (LLC) that merged with Bear Stearns. This allowed the LCC to manage Bear Stearns’ assets and minimize financial disruption.
The role of the Treasury Department is to promote economic growth and prosperity and ensure the financial stability of the United States. The department’s responsibility was to advise the President on financial and economic matters and encourage economic growth (Kirk, 2009). During the crisis, the Treasury offered Bear Stearns $30 billion to bail it out.
A moral hazard occurs when a person is involved in risky behavior, which has expected outcomes in which another person bears the costs in case of unfavorable outcomes. Systemic risk is a possibility that one event in the company might lead to a crisis. The way these two factors contributed to the economic downfall was that the institutions that had loans expected the financial crisis, but they received protection from the government (Kirk, 2009).
Paulson was concerned about the moral hazard because he did not want people to think that the government is ready to bail off the company whenever it needs (Kirk, 2009). This act resulted in the stock sale for $2 instead of the initial $30 and Bear Stearns’ bankruptcy.
One of the banks’ incentives to give out bad loans was that the mortgage loaning companies Fannie Mae and Freddie Mac increased demand for houses as they were ordered to improve homeownership. Realizing that these companies could buy up all mortgages, banks increased loaning. The next incentive was related not to quality, but quantity. So the riskiness of the mortgages did not concern bank employees because they could either be bought up by Fannie Mae and Freddie Mac or securitized (Kirk, 2009).
The laws should be introduced that restrict the number of mortgages people can get because of the speculative buyers. Before the crisis, when banks offered low rates for houses, these buyers entered the market, drove up the demand, and cut into the supply (Kirk, 2009). All of this resulted in a dramatic increase in prices. The investors could not keep up and began to leave the market. Demand decreased, and so did the prices, which led to the collapse of the market. Thus, the problem for the free market is that there is an imbalance between demand and supply.
Capital injection is a contribution of capital, in the form of money or debt, into an institution or company. Usually, the company that injects is experiencing financial distress. Injections were needed to keep the financial institutions on the float and compensate for toxic assets (Kirk, 2009).
Banks refused to lend money to each other because they feared that other banks would not pay them back. Banks stopped lending, although it was the basic and usual operation that financial institutions had been practicing since their establishment (Kirk, 2009). It was not only mortgages but also small businesses, car loans, and commercial paper borrowing. The market froze, and it resulted in Lehman Brothers’ bankruptcy. No one could predict the event.
Terrified of the massive collapse of the economy, Barnacle and Paulson headed to Congress to ask them to take measures. Paulson demanded $700 billion from the taxpayer to buy toxic assets from the banks. He also asked for no intervention from the agency and court (Kirk, 2009). The reaction of Congress was toxic as they were furious. The voting resulted in the bill’s failure, but it raised the question of integrating another plan that involved capital injection.
AIG, which sold credit swaps worth a trillion dollars, was America’s largest insurance company. The failure of such an influential organization would result in the collapse of the whole economy (Kirk, 2009). That is why the government decided to lend AIG $85 billion while refusing Lehman Brothers. The ownership stake of 80 percent now was controlled by the United States government.
Two of the largest mortgage companies, Freddie Mac and Fennie Mae, lost 60% of stock value. The government placed them into conservatorship to increase its liability. The companies were victims of circumstances as the government could not sell enough shares and return Mae and Mac private ownership (Kirk, 2009).
The leaders of the US banks had to accept injection because it was the only option to get the economy out of trouble (Kirk, 2009). His rationale was to return the nation’s confidence in the banking system and let them lend again. After each CEO signed the document with conditions, Paulson spent $125 billion. He overcame his principles not to let the government take a significant role in the economic system.
I think the crisis is more likely to originate in Europe. For example, populism in the UK, division, financial resilience, can be the cause of the next economic collapse. The government has skillful staff in the Treasury and the central bank, but a weak political system would be able to cover them. Although the financial system has improved so far, the dept and growing toxic environment can lead the crisis to occur sooner.
Reference
Kirk, M. (2009). Inside the meltdown [Video]. Frontline.