Essay Sample: Key Events Leading to the 2008 Financial Crisis

Published: 2022-03-30 17:09:10
Essay Sample: Key Events Leading to the 2008 Financial Crisis
Type of paper:  Course work
Categories: Banking Crisis management
Pages: 7
Wordcount: 1923 words
17 min read
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A number of events led to one of the worst financial crises in history in 2008. In 2007, the housing crisis deepened as foreclosures rose and banks that had invested a lot of money in mortgages suffered losses. As the crisis reached Wall Street, Freddie Mac, a mortgage giant by then, declined from buying risky loans from subprime investments. In April, subprime lender New Century filed for bankruptcy and subsequent court protection. This was followed by American Home Mortgage Investment in August, which specialized in mortgages (Securities and Exchange Commission, 2008, np). By 2008, the American economy was in recession and the financial crisis in subprime mortgages had infected and spread to the country's credit markets. In January 2008, the biggest bank in the US, the Bank of America agreed to buy Countrywide Financial. In March, the Federal Reserve agreed to offer Bear Stearns assets guarantee for $30 billion as the investment bank was being sold to JPMorgan Chase (Wallison, 2009, np). In the same month, the Lehman Brothers filed for bankruptcy. The last two private investment banks Goldman Sachs and Morgan Stanley became holding banks and were subjected to regulation by the Federal Reserve (Citigroup, 2008, np). The federal regulators closed the Washington Mutual Bank, constituting a major failure in the banking history. In the same month, Wall Street came up with a financial rescue package; the Troubled Asset Relief Program (TARP) and was rejected by Congress until it was revised and then signed by then president Bush. Citigroup, General Motors, and Ford received TARP and were rescued from the crisis albeit with a number of federal regulations.

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Causes of the Financial Crisis of 2008

The origin of the 2008 financial crisis can be dated to many years before it actually happened although the primary cause of the crisis was deregulation in the country's financial industry. The deregulation gave permission to banks to trade with hedge fund with its derivatives (Fratianni & Marchionne, 2009, np). To support the sale of the highly profitable derivatives, banks required and demanded more mortgages. The kind of loans that they created was interest-only, which could be afforded more by borrowers of subprime. In 2004, as the rates of interest for the new mortgages reset, the Federal Reserve raised the fed funds rate (Amadeo, 2017, np). With these changes, the prices of houses began to fall considerably as their supply was too high compared to their demand. Homeowners who could not afford mortgage payments were trapped as they could not sell the houses due to lower prices (HM Treasury, 2011, np). Eventually, when the value of the derivatives fell as well, banks stopped lending to other banks and this was what created the financial crisis.

Deregulation

Deregulation as a cause for the financial crisis can be further dated to 1999 when the Gramm-Leach-Bliley Act made a repeal of the Glass-Steagall Act of 1933 (Gray, 2008, np). This repeal permitted banks to use their deposits as an investment in derivatives as a way of enabling American banks to compete with foreign banks (Gray, 2008, np). To protect their consumers, the banks promised that they would only invest in securities that contained low risks. They would, however, get overtaken by ambition. In 2000, the Commodity Futures Modernization Act was passed to exempt swaps of credit defaults and many other derivatives from regulations by relevant institutions.

These bills were both written and advocated for by Phil Gramm, the then governor of the state of Texas and who was the Chairman of the Senate Committee on Banking, Housing and Urban Affairs (Zhang, 2007, np). The energy company Enron wished to engage in the trading of derivatives through its futures exchanges online. The company's management argued that the trading of foreign exchange derivatives gave foreign firms operating overseas unfair advantage against American firms. This arrangement, however, was set to benefit only the big banks had the resources to trade in the derivatives (Emergency Economic Stabilization Act, 2009, np).

Securitization

Hedge funds were a major player in the financial crisis. As banks sold mortgages, they made new loans with the money they received from the mortgages. This meant that even though they collect payment for the mortgage, they would send the money to the hedge fund, who would also send the money to their investors. Everyone involved in the transaction would make a cut along the process and this s one reason why hedge funds became so popular. These transactions were basically free of risk both for the bank and the hedge fund. Instead, it was the investors who took all of the risks in case they defaulted but again, they did not have to worry about the risk as they had insurance and this was the trend referred to as credit default swaps. These swaps were sold only by stable insurance companies like AIG and thanks to the insurance, investors could snap up the derivatives.

A derivative that contained both real estate and insurance was extremely profitable and soon, demand for these derivatives increased. As this demand grew, so did the need for more mortgages by banks in order to be able to back the securities (Bernanke, 2005, np). To satisfy the growing demand, mortgage brokers and banks extended home loans to anyone that required one (Board of Governors of the Federal Reserve System, 2009, np). However, rather than the actual home loans, banks opted for subprime mortgages as they made more money from them.

The Expansion of Subprime Mortgages

The incentives for subprime mortgages for banks as explained above created a lucrative desire for subprime mortgages. Many American investors were handed these mortgages without the efficient scrutiny of their effectiveness by the banks, which were more eager to make a killing from the loans (Gramlich, 2007, np). Another factor that led to the increase of the subprime mortgages was the Financial Institutions Reform Recovery and Enforcement Act of 1989. This act led to increased efforts to the enforcement of the Community Reinvestment Act, which was keen on eliminating the redlining of poor neighborhoods by banks, which in turn, was responsible for the growth of ghetto neighborhoods (Walsh, 2008, np).

Interventions to Strengthen the Financial Management of Banks Post the Crisis

Back to Original Business

The country's financial industry put in place a number of measures to prevent a recurrence of the crisis and remedy the effects of the same. The first intervention was for banks to go back to their traditional business, which s banking (Wallison, 2008, np). The core functions of the banking business now include providing financial advice, facilitating trading, lending money, and moving away from practices like repackaging and reselling loans (Office for Budget Responsibility, 2011, np). Banks have also moved away from the practices of putting capital into hedge funds or private equity.

Improved Regulation

The improved regulation includes making the banking business safer and sounder for all stakeholders. One of the regulations is for banks to hold more liquid assets and capital rather than reinvesting it. They are required to be more rigorous in their risk-taking and management and testing stress. For instance, banks are now required to update their records of the losses they make immediately they do so that the bank's financial position can be accurately reflected.

Global Restructuring

Banks in the US are now working with other banks across the globe to make their structure more global. This has and will ensure that banks enact policies and practices that do not only suit their domestic market, but also the international market. Such globalization would also ensure that there are sufficient checks and balances to rule out malpractices that were responsible for the crisis (America International Group, 2009, np).

The Client-First Approach

During the time leading to the crisis, banks put their own interests first before those of their clients. As an intervention, banks are now having to put the interests of their clients first to prevent them from practices that will jeopardize the security of their clients' investments. Before the crisis, banks focused on a narrow client base and still made a lot of money (FSA, 2008, np). However, now, banks have to focus on a wide client base both n geography and industry so as to spread the risk and improve their customer service. Banks like Morgan Stanley now have clients from around the globe

Staffing

After the crisis, treasury and banks realized the need for staffs with diverse banking skills to enable economic recovery and stabilization of the banking sector and the economy at large. Experts in the fields of traditional banking were contracted as well as those in areas such as debt reserves management, asset protection scheme, recapitalization, and project management. Other areas of management that were previously not considered as important were given more weight after the crisis (Adrian & Hyun, 2008, np). These included risk management and communication processes within banks and between banks and external players.

All of these interventions have worked together to return normalcy to the American banking sector and most importantly, to remedy the losses made during the crisis. What was more important was the fact that the banks and their management took the crisis seriously, empathized with the situation of their clients, and resolved to work hard and ensure that the same does not happen (Federal Deposit Insurance Corporation, 2009, np). Almost a decade later, the American banking sector is going strong and the economy as a whole keeps improving every day.

Case Study of Barclays Bank

A study of Barclays bank would shed more light on the course of recovery of banks from the crisis. Away from the US, Barclays Bank was involved in a scandal involving its dealings with derivatives. Libor is London's lending rate for banks and it is an important and critical interest rate in the country's finance industry (House of Commons Treasury Committee, 2009, np). As early as 2005, there were claims and further evidence to prove that Barclays Bank had attempted to manipulate the rates of the dollar Libor and the Euribor, which is the European equivalent of the Libor. This was in the interest of traders of derivatives and other banks (BBC News Business, 2013, np). This misconduct was rampant within the bank and its branches in New York, Tokyo, and London and other external traders.

In the years between 2005 and 2009, derivative traders with Barclays Bank made over 250 requests to fix the Euribor and Libor rates illegally (Barclays PLC ADR, 2016, np). In 2007, with the collapse of other major banks including Northern Rock, public scrutiny was drawn to Libor. Manipulating Libor submissions, the bank was able to give a healthier picture of itself and its ability to raise funds. These submissions drew the attention of the media. To avoid such speculations, Barclays and other banks set their Libor status lower than the actual rates. Barclays sought to conceal its activities this entire time and thus, created the wrong picture of its financial status.

Barclays Bank's financial ratios since 2008 to 2016 can help elaborate the effects of its financial activities. From the analysis of the bank's revenue, Barclays registered higher revenues in the years of the Libor crisis at GBP millions 24,184 in 2008, 30,202 in 2009, and 33,033 in 2011. However, this figure declines in the years after this, at 25, 749 in 2012 and 21, 941 n 2016 (Barclays PLC ADR, 2016, np). The revenue rates began declining after the truth about the bank's Libor scandal was unveiled. There is also a sharp difference in the bank's operating income amou...

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