The great depression

The Great Depression in the 1930s triggered off greater caution among different countries, particularly the United States, in protecting the integrity of the banking sector and in keeping the national economy in good shape. Perhaps the most important measure that the US government undertook during this time was to enact the Glass Steagall Act of 1933, which effectively separated investment from commercial banking. This piece of legislation was enacted precisely to safeguard the banking sector from collapsing upon itself because of too many unpaid debts.

However, this was subsequently repealed by the Gramm-Leach-Bliley Financial Services Modernization Act of 1999 (Araneta 2009), which led to the complete merger among commercial banks, investment banks and insurance companies. The so-called firewall between in the business now gone, underwriting for the debts incurred by bank A (commercial bank), for example, can now be done by bank B (investment bank).

Exactly ten years after the latest legislation on the banking business was ratified, the US experienced another substantial crash in its domestic economy, which created a domino effect that affected other nations across the globe. The massive loss of confidence by the public of investors and financial institutions, coupled with their unwillingness to spend their cash (which was actually needed to keep the economy's wheels going again) brought us the worst global economic downturn since the Great Depression. This event is even more widespread than the Asian Financial Crisis in 1997.

Simply put, the latest financial crisis was the result of unwise and unregulated credit practices. In layman's terms, everything happened because there were too many debts that remained outstanding, and yet there was too little money to pay them all off. Financial analysts believe that the Wall Street crash in the last quarter of 2008 has been boiling for a long time, and erupted only when the situation became too volatile for damage control to be effectively undertaken.

This episode started when the Treasury nationalized Federal National Mortgage Association (popularly called Fannie Mae) and Federal Home Loan Mortgage Corporation (or Freddie Mac) on September 8. Their combined assets are over $5 trillion (Levitt, 2008). These firms help guarantee the majority of the mortgages in the United States. Their unique role in the American economy, particularly the domestic housing market, prompted the US Federal Trueasury to try and salvage the companies.

Fannie and Freddie helped guarantee mortgages (provided they met certain standards), funding these guarantees by issuing their own debt, which was in turn tacitly backed by the government (Levitt, 2008). The government guarantees allowed Fannie and Freddie to shoulder a bigger debt allocation than a normal company. Because of the government subsidy, the company was supposed to reduce the mortgage cost for homeowners and thus make obtaining credit easier.

But instead of wisely using the government subsidy, the two companies invested in mortgage-backed securities that were also backed by sub-prime mortgages. It is at this point that we can see that the debt of the two companies continued to balloon even as the value of the properties with which they can pay shrank with every mortgage in the securities that the companies acquired.

The situation culminated in the US Treasury's direct involvement when it became apparent that Frannie and Freddie could no longer bear the heavy burden of their debts. The government took over the entire companies because investor was willing to put in money in an already extremely risky ventureif the debts were defaulted upon, a lot of businesses would come crashing down.

The systemic breakdown of large companies across the globe began when Lehman Brothers, a Wall Street firm even bigger than Bear Stearns, filed for bankruptcy in September 15, 2008. New York based Lehman Brothers, which was founded 158 years ago, was forced to file for bankruptcy protection after trying to finance too many risky assets with too little capital. It was the largest bankruptcy filing in US history.

Lehman Brother's rival company Merrill Lynch is sold to Bank of America to prevent it from meeting the same fate as the former. These two large banks bowed under the pressure of the credit crunch in the same month, which heralded the start of the systemic breakdown earlier feared by other economists. Both Lehman Brothers and Merrill Lynch survived the Great Depression and several world wars, but they could not survive the credit crunch of 2008.

The US Federal Treasury also had to bail out another large firm, the American International Group, which was then the biggest insurance company in the world. Because of the extensive interests of AIG across many countries, it was feared that the company's bankruptcy would create huge repercussions in the global economy. The company's loss was mainly attributable to its insurance contracts that were dependent upon the sub-prime real estate investments that went down the drain.

As we can see, the root cause of the credit crunch was the unwise credit lending by some of the world's largest and supposedly most stable financial institutions. Most of the investment banks relied on the housing market to turn a profit, lending out to people who did not meet their usual rigid standards. When the housing market bubble burst, they were the ones who were left to bear the losses of huge amounts of unpaid debts (Whipps, 2008).

What is being done today apart from the government takeovers and subsidies is a realignment of the credit policies of investment banks and other financial institutions. The biggest mistake of the banks and lending firms was that they loaned too much money too fast, to too many people with unsatisfactory credit standing. When the debtors could not longer pay the amortizations, the banks usually found that the properties they can foreclose are insufficient to cover the full amount of the loan.

The state can only do so much to extend a lifeline to companies that have considerable ties to other parts of the financial system and the economy, such as what happened in the case of Frannie and Freddie. But even the US could not extend unlimited assistance to every company that begins to experience serious problems about its portfolio, and such firms will either have to close down or go through a merger to save itself. The Wall Street downturn would not have happened if the financial institutions were only more careful about choosing the people to whom they will loan money, and the properties that will stand as security in case of the mortgagor's default.

The 2008 crash can definitely happen again if companies continue to take high risk ventures without analyzing the situation thoroughly. The most viable solution, at least within the context of the US, is the reenactment of the Glass Steagall Act or a similar legislation that will help protect the interest of private firms and individuals who are at the mercy of investment and commercial banks, which can go under any time their investments fall through. At the same time, financial institutions also have to be more selective and strict about the mortgages that they approve. Generating profit is not a bad thing, but caution also has to come into play.

References

  • Araneta, Val. 'Wal Street and the financial crisis. Business Mirror. 17 March 2009. Retrieved 6 April 2009 from http://www.businessmirror.com.ph/home/banking-a-finance/7590-wall-street-and-the-financial-crisis.html.
  • Levitt, Steven. Diamond and Kashyap on the Recent Financial Upheavals. 18 September 18. Retrieved 6 April 2009 from http://freakonomics.blogs.nytimes.com/2008/09/18/diamond-and-kashyap-on-the-recent-financial-upheavals/.
  • Whipps, Heather. "The Long History of the 2008 Financial Mess." 19 September 2008. Retrieved 6 April 2009 from http://www.livescience.com/history/080919-history-banking-industry.html.

Picture credit:

  • Shah, Anup. 2009. Global Financial Crisis. Retrieved 18 February 2010 from http://www.globalissues.org/article/768/global-financial-crisis.

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