Last week was the most turbulent week in money since the Great Depression.
The following major financial institutions experienced bankruptcy failure or severe problems over the last few months: Freddie Mac, Fannie Mae, Bear Stearns, Merrill Lynch, Lehman Brothers and American International Group.
Finally on Saturday, the chairman of the Federal Reserve Bank and the secretary of the treasury decided, rather than deciding on a case by case basis as each financial institution cried for help, to give an unprecedented $700 billion rescue of all the bad mortgages in order to stop the problems. Loquitur spoke with Dr. Mary Harris, associate professor of finance and chair of the business department. She explained the basics of what happened.
What caused this financial crisis?
Bad mortgage loans are where this started. For a number of years banks have been making increasingly risky loans, called subprime loans. Subprime loans are loans made to people with risky credit who could not afford or even get a regular loan. ?
Loan officers even encouraged bad credit risks to lie about income. The banks then bundled good and bad loans together and sold the packages to large investment companies. These investment companies became increasingly highly leveraged compared to commercial banks. They took on a lot of risk in trading with these bundles of good and bad mortgages and had less and less solid assets to back up the loans. ?
Investment banks didn’t have the same government scrutiny and regulation as commercial banks, which enabled them to buy and sell these bad mortgage loans. “You have a lot of risk, not a lot of regulation and you end up with a financial crisis,” Harris said. ?
When housing prices leveled off in 2006, people with outsized mortgages found they could not sell their homes and began to see their homes go into foreclosure.
What companies got in trouble doing this risky lending?
In March, investment bank Bear Stearns started to go under and was bought by JPMorgan Chase with government help. Countrywide then had to be bought by Bank of America. Then, Fannie Mae and Freddie Mac, two lenders sponsored by the government, had to be bailed out. Lehman Brothers filed for bankruptcy and Merrill Lynch had to be bought.
Why was AIG bailed out this week?
The government bailed out AIG, American International Group, for $85 billion, on Tuesday, Sept. 17. The government now owns 79.9 percent of the company. Harris explained that AIG was just “too big to fail” and that is why the government allowed Lehman Brothers to go under, but not AIG. Morgan Stanly and Goldman Sachs went from investment banks to bank holding companies
“If they [AIG] failed and the repercussions throughout the entire financial system and the economy would be detrimental to the country is when the government needs to step in,” Harris said.
Why did the government promise $700 billion to stop all this on Saturday?
The head of the Federal Reserve, Fred Bernanke and the Secretary of the Treasury Henry Paulson decided that instead of meeting crisis after crisis that they would draw up a plan to buy the bad debt if necessary. They are trying to get Congress to pledge $700 billion.
Could this have been foreseen/prevented?
“The way things typically happen is we have a crisis and then out of the crisis comes the regulation,” Harris said. After the depression, the Federal Deposit Insurance Corporation was created and banks were split from investment companies. Investment banks make large amounts on money by taking on greater risk than commercial banks. When the economy is good and profits are strong, no one thinks about the risk.
What does this mean for graduating seniors & the job market?
For graduating seniors, the job market is going to be extremely difficult and not just for finance students; it spreads across the spectrum because as borrowing is becoming tougher, companies cannot expand and hire new employees. Harris advises seniors to get their resumes out now. “With the economy weak and the financial markets unsteady, it’s going to be probably one of the tougher years our graduates are going to face,” Harris said.
What happens next?
The difference between this crisis and the Great Depression is that the Federal Reserve believes it knows what to do this time and is aware of the policies that should be implemented. However, the $700 billion proposal has met skepticism on the part of many. Conservatives question why taxpayers should bail out private businesses and liberals ask who is helping the people who are losing their homes in this crisis.
Harris explains that the problem is that our country is currently experiencing inflation and a recessional economy, both of which require two different plans of action, leaving us in stagflation.
In order to come out of this, confidence needs to come back to the stock market. We most likely won’t see this confidence resurface until the results of these bailouts are clear. “With the bailout package, with what the Fed is doing now, we will hopefully see confidence come back to the system but it’s not going to be a quick turnaround,” Harris said.