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Managing a business during a Financial Crisis

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Date added: 17-06-26


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According to business dictionary, financial crisis is a condition in which the money supply is exceeded or more than the money demand. As a result, liquidity in the market is becoming lesser. In other words, the availability of the money in the market becomes lesser. The available money is withdrawn from banks. Eventually, there are only two ways for bank to handle this problem. Banks either can sell other investments to make up for the shortfall or to collapse as unable to withstand with the crisis. In addition, the financial crisis in year 2007 up to the present is a crisis which caused by a liquidity shortfall in the United States banking system.

The financial crisis brings a severe effect to community and banking industry. From the perspective of financial market, it has resulted in the collapse or been bought out of large financial institutions including banking institutions, index in the world stock market had fallen, and the effort of bailout financial systems of Wall Street titans by national governments. The entire financial system is affected by financial crisis.

From the perspective of community, the financial crisis has impacts on almost every corner in the world and also every one of us who is living on this earth. The financial crisis has brought to the failure of key businesses, consumer wealth also decreases as the value of money is depreciated, influences the growth of the economy as inactive in economic activity. Eventually, standard of living of community is decline as the economic activity is the indicator of a country's growth.

The Lehman Brothers' bankruptcy on September 15, 2008 was a major surprise to a global financial system which already suffering from the mortgage crisis and credit crunch. This collapse of investment bank sparked the worst financial crisis.

The victims of the crisis consist of many Giant Corporation, such as Lehman Brothers and also some mortgage giants such as Fannie Mae, Freddie Mac, insurer American International Group (AIG), and banks Merrill Lynch, Washington Mutual, and Wachovia. These giants had been takeovers by the government or to be acquired by competitors at low prices.

Causes of Financial Crisis 2008

One of the factors that make the financial crisis happened is the cheap credit which inspires people buy houses by credit especially people in the middle or lower level of income or make investments that is based on the pure speculation. The presence of cheap credit made more money ready in the market. Increasing in money supply aroused consumption and expenditure. When the demand on goods and services increased, price increased as well. As this situation continued, eventually inflation happened.

Another cause of financial crisis is the greedy of mortgage lenders who made sub-prime loan to people who have poor credit ratings such as borrowers with a record of delinquent payment, previously charged-off loans, bankruptcies or even court judgment to pay off by charging higher interest rate. The loose regulation also made people easier to get loan and this made the demand of houses became higher and drove up the house values. Thus, lenders, insurers and investors made more money. Consequently, many borrowers could not afford to pay their home mortgage payments with adjustable rate mortgages (ARMs) because the monthly home loan payments were rising skyward. Thousand of home mortgage foreclosures as scores of lower-income home buyers, especially those with subprime mortgages. Lenders were suffered from illiquidity and unable to pay to investors. Mortgage-backed securities became more risky and the value of the securities was dropping, thus caused some investment firms like Lehman Brothers get suffer from it. Besides, insurers who insured those bad mortgages were not get away from suffer and involved in trouble as well.

Impacts of Financial Crisis 2008

Impact on Financial Market

According to Bloomberg Businessweek, the Standard & Poor's 500-stock index, the broad U.S. stock index, dropped 9% in September 2008 and another 17% in October 2008 as investors worried the world's financial system would stop operating after the fall of Lehman Brothers that cause the world financial crisis.

Many individual investors faced huge losses in almost every asset class such as equities, corporate bonds and real estate except for cash and government bonds which are less risky. Due to the sudden and huge losses faced by investors in the financial market, so when some clients came and seek for advices from financial planners, they have claimed that they do not want to expose to the stock market at all. (Frank, 2009). Being of this, the stock market had declined and become inactive as there were lesser investors trading and push the stock market.

According to Professor Vickie Bajtelsmit, Chair of the Finance and Real Estate department at Colorado State University, investors often sell at the bottom of the market due to the huge losses that individual investors faced during crisis. They do not buy in the stock or other investments until investments are well and stable along their way to recovery. Therefore, they essentially lock in the losses and miss out on gains due to the fear appear in their mind. They are fear to take risk again.

Bear Stearns

The Bear Stearns Companies, Inc. was a global investment bank and securities trading and brokerage firm based in New York City. In addition to this, it was the fifth-large U.S. investment bank before its collapse. The main business areas of Bear Stearns were capital markets which consisted 80% of its business including equities, fixed income, investment banking, 10% of its business areas was wealth management, and another 12% was global clearing services. Besides, Bear Stearns was involved in securitization and issued huge amounts of asset- backed securities.

Before Financial Crisis

Bear Stearns had survived major crisis since it was founded in 1923, such as the Great Depression, World War II, the 1987 market crash and 11 September 2001 attacks.

In the months following 11 September, Bear Stearns's executives were relied heavily on the manufacture and the sale of mortgage-backed securities. In the short run, Bear Stearns's decision to become a leader in manufacture and the sale of mortgage-backed securities resulted in huge profits for them. Bear Stearns capitalized on the boom of mortgage market that happened in 11 September when the Federal Reserve loosened the money supply.

Another source of profit of Bear Stearns was a small hedge-fund division with $45 million equity investment. Bear Stearns has established a hedge fund called High-Grade Structured Credit Fund with money from outside investors. This hedge fund invested in low-risk, high-grade debt securities, such as Collateralized debt obligations (CDOs), which has the investment ratings of AAA or AA. The fund used leverage to generate returns by borrowing money in the low-cost, on the other hand buy higher yielding and long-term CDOs at short-term repo markets.

In August 2006, Bear Stearns opened a second fund called the Enhanced Fund that used more leverage and it was more risky than the High-Grade Structured Credit Fund.

High-Grade Structured Credit Fund never had a losing month for 40 months and achieved a 50% cumulative return. The Enhanced Fund also performed well during its short existence.

During Financial Crisis

Subprime Mortgage Hedge Fund Crisis

The subprime mortgage crisis is an ongoing real estate and financial crisis because of the fall in U.S. housing prices. Securities backed with subprime mortgages which were widely held by many financial firms faced losses due to lost in the securities value.

During the weeks of July 2007, Bear Stearns disclosed that the two subprime hedge funds had lost nearly all of their value due to the rapid decline in the market for subprime mortgages. A report in the New York Times dated September 21 noted that Bear Stearns posted a 61 percent drop in net profits due to their hedge fund losses. In addition to this, Bear Stearns was writing down a further $1.2 billion in mortgage-related securities. Besides, Standard & Poor's downgraded the company's credit rating from AA to A.

After financial Crisis

Federal Reserve Bank of New York and J. P. Morgan Chase had provided emergency funding to prevent the financial collapse of Bear Stearns in year 2008. J. P. Morgan Chase is a global investment banking and securities firm. It is also one of the Big Four banks in United States.

The Federal Reserve issued a non-recourse loan of $29 billion to J. P. Morgan Chase for it to bail out Bear Stearns. J. P. Morgan Chase is just paying $10 a share to take over Bear Stearns which a little compared to year 2007 which was trading for as high as $170 a share. The purchase price indicated that how far the value of Bear Stearns dropped with the collapse of its two big hedge funds.

As the consequences of failure of huge investment bank, U.S. financial system is almost collapse if the Federal Reserve did not take action to rescue Bear Stearns. Bear Stearns's shareholders had faced losses and this incident has shrunken the investors' confidence in investing in stock markets.

Fannie Mae and Freddie Mac

Fannie Mae (Federal National Mortgage Association) was established in 1938, and its brother company Freddie Mac (Federal Home Loan Mortgage Corporation) was founded in 1968. Both Fannie Mae and Freddie Mac are government sponsored enterprise (GSE) which created to expand home ownership. In addition, it is also provides a secondary home loan market for buyers.

Fannie Mae was a middleman and never made loans directly to the consumer. It buy mortgages from approved mortgage sellers, either for cash or in exchange for a mortgage‐backed security (MBS) for a fee, carries Fannie Mae's guarantee of timely payment of interest and principal. Fannie Mae keeps some but resells most to investors guaranteeing to pay off a loan if the borrower defaults. By purchasing the mortgages, Fannie Mae and Freddie Mac provide banks and other financial institutions with fresh money to make even more new loans, thus increasing the pool of homeowners and allowing Fannie Mae to continue making large profits.

Before Financial Crisis

Due to the political pressure, Fannie Mae and Freddie Mac have had to expand their home ownership to middle or lower‐income families or poor credit rating borrowers and this led to a riskier mortgages being issued, as well as riskier MBSs. There was a actual risk was that Fannie Mae might guaranteed and pledged those questionable mortgages and lose out when many borrowers were not capable to discharge their payment or obligations.

During Financial Crisis

Unfortunately, in year 2007, the subprime mortgage crisis began. Poor credit ratings borrowers were unable to pay their mortgages payment especially with adjustable rate mortgages (ARMs) because the payments risen sharply. This made a sudden rise in home foreclosures. Consequently, house prices had fallen and cause more and more foreclosures added to the large inventory of homes. Besides, strict in lending standards made it difficult for potential borrowers to secure new mortgages. The decline in house prices led to a huge amount of losses for Fannie Mae and Freddie Mac.

The US government attempted to calm the market in July 2008 because government believes that Fannie Mae and Freddie Mac play an important role in the US housing finance system. Therefore, Treasury Department and the Federal Reserve decided to take steps to build confidence in the companies. The steps included permitting both corporations enter to Federal Reserve discount window and removing the prohibition and allowed Treasury Department to buy Fannie Mae's and Freddie Mac's stock. However, in August 2008, shares of both Fannie Mae and Freddie Mac had plummeted more than 90% from their one-year prior levels.

At the same time, their investments in other financial institutions reported losses as well. Their capital adequacy ratio of 0.5% was unable to meet up to the requirement of subprime lending crisis. Creditors and some responsive investors responded it by limiting and restraining the credit supply and selling those shares.

Treasury Secretary, Hank Paulson asserted that these losses could jeopardize the US financial system entirely because it already struggling by housing markets and it could have collapsed if Fannie Mae and Freddie Mac had failed. Besides, the fall in the securities of both companies would result in losses to many institutions like pension funds, mutual funds, and global economies. Many US banking institutions own stock in Fannie Mae and Freddie Mac, all are now facing pending dividends in addition to a huge and visible loss in share value. Some banks may also have problems with capitalization due to the related loss of invested funds. Fannie Mae and Freddie Mac had great impact on our financial system that a failure of one of them would give rise to a great turmoil in our financial markets.

Besides, the credit default swap (CDS) market is concerned as well, the federal bailout of Fannie Mae and Freddie Mac being looked on as a type of bankruptcy. So, a new protocol is being developed to evaluate and settle Fannie and Freddie's credit default swaps accurately.

After financial Crisis

Consequently, in September 2008, the Federal Housing Finance Agency (FHFA) announced the federal takeover of Fannie Mae and Freddie Mac and placed them under conservatorship and took control of both the companies' assets and operations.

The bailout of these two government sponsored enterprises (GSEs) happened in the mid of the current credit crisis. At the time of the takeover, Fannie and Freddie owned or guaranteed about half of all American home loans and had total obligations of $5 trillion. So, making their conservatorship is one of the largest and potentially costliest federal bailouts of private companies in US history. It is also a most expensive bailouts ever faced by the taxpayers in the US history.

The value of the companies' common stock would be diluted but not die out whereas US government may protect the holdings of other securities such as company debt and preferred shares. Government also make quarterly injections as the companies' losses warrant.

As a result of the government's intervention, the cost of borrowing for Fannie Mae and Freddie Mac should turn down, because the government will be standing behind their debts. Although the US Treasury has made a solid $200 billion commitment to maintain financial operations and support mortgage guarantees, but stockholders will bear any primary losses and taxpayers may eventually be in risk of covering the firms' combined liabilities. The government conservatorship is planned to maintain and sustain the financial stability and capitalization of both Fannie Mae and Freddie Mac as well as to prevent further losses when possible.

Fed's responses

In order to minimize the effect of the financial crisis, Fed had taken some actions to response to this financial crisis. First of all, we need to investigate on its monetary policy. Federal considered the dual mandate which is price stability and maximum employment. So, policymakers conduct monetary policy through open market operations, discount rate and reserve requirements.

By changing the discount rate, Fed manages to influences the demand and supply of balances at the Fed and shifts the actual federal funds rate toward the target which been set during the meetings of the Federal Open Market Committee. After decreasing the target federal funds rate, bank borrowing became less expensive and more affordable to bank because the spread between the target federal funds rate and the primary credit rate was narrowing. This spread was 100 basis points in the early August of year 2007 but narrowed it to 25 basis points to make available source of liquidity to strong financial institution. However, the rate offered to banks is still an above-market rate.

On the other hands, Federal Reserve requires the depository institutions maintain reserve requirement or in other words amount of funds either in the form of vault cash or deposits with Federal Reserve Banks. Changes in the reserve requirement formally will influence the bank liquidity and the lending capacity in the market. Besides, Congress was allowed Federal Reserves to pay interest on required reserve balances and surplus balances. This will helps Federal Reserve to expand its balance sheet to provide the liquidity for financial stability.

Next, Fed formed a new lending procedure in the form of the Term Auction Facility (TAF) and the Primary Dealer Credit Facility (PDCF), and transformed their securities lending program and introducing the Term Securities Lending Facility (TSLF). The TAF offers commercial banks funds through an unknown auction facility to remove the stigma attached to normal discount borrowing. The PDCF extends lending rights from commercial banks to investment banks whereas TSLF allows investment banks to borrow Treasury bills, notes and bonds using mortgage-backed securities as collateral. All of these programs offered funding for terms of roughly one month at relatively favourable interest rates.

Fed also made adjustments to original procedures. Firstly, they extended the term of their repurchase agreements to 28 days and accepted mortgage-backed securities. Moreover, Fed extended the swap lines to European Central Bank and the Swiss National Bank that allowed them to offer dollars to commercial banks in their currency areas.

Central bank's balance sheet is one of the important elements in this financial crisis. There are two principles in managing its assets and liabilities. First, size of the balance sheet must been controlled or in other words is the quantity of monetary base. By changing the level of the monetary base, Fed can keep the market-determined federal funds rate near to their target.

Furthermore, central bank is responsible to control the composition of its assets. Fed can make decision on which assets to hold. These assets include treasury securities, foreign exchange reserves and others. The assets of Fed hold highly related to its new programs. For example, by the end of March 2008, Fed had committed more than half of its assets to the new programs such as $ 100 billion to the Term Auction Facility. Changes in the combination of central bank assets are projected to control the relative price of a financial asset.

In conclusion, Fed broaden its traditional programs and implemented non-traditional programs in order to improve credit markets through infusions of liquidity and restore the confidence in turn to maintain financial stability.

Recommendation

In our opinion, we think that Fed should review its policies. Fed was not responding well to reduce the impacts brought by financial crisis. For example, Fed's action of cut interest rates and loosen the money supply in market. Instead of lowering interest rate, Fed should charge higher interest rate to make the emergency credit more costly for better- targeted lending. Besides, high interest rate discourages consumption. As a result, inflation will decrease.

On the other hands, Fed's responses had forced central banks in countries outside U.S. which manage their exchange rates against the dollar to import inflation rather than deflation. Consequentially, these countries' currencies have become undervalued. As their real interest rates had declined, these countries in fact are exporting inflation back to the US. So, emerging markets need to tighten their monetary policy further in order to reduce inflation. By revaluing against the dollar, these countries can prevent inflationary pressures from the U.S.

Besides, we think that government should promote a recapitalization of the banking systems to enhance it. This can help to inject some public capital into banks and pressure banks to raise additional private capital. Government also have to ensure that all the depository institutions must maintain the adequate reserves in their vault.

Lastly, government can loosen the repayment terms on mortgage agreements in order to reduce the defaults of payments and foreclosures. Government is also encouraged to expand its monetary and fiscal policies abroad. This is because the increase in spending in countries outside U.S. can offset the decrease in U.S. consumer spending. Besides, this allows US to offset the fall in housing construction by increase in exports activities.

Conclusion

In conclusion, financial crisis can harm the financial markets either in US market or global and the economy will experience recession. So, Fed as the central bank for U.S. is bearing heavy responsibilities in the market. All the decisions made should consider many factors so that the market would not collapse due to the crisis.

Financial crisis had caused panic to people in the markets. Panic drives people to sell risky assets to raise money in cash. People save more and spend less. Besides, corporations also cut their spending and investments. Worst, some corporations faced difficulty to defend themselves and finally fall into bankruptcy.

Even though some actions had taken by Fed and Treasury department to solve this financial crisis, but the actions taken did not fully solve the problems and some actions even bring the opposite effects in the markets. So, government must ensure the market stability and liquidity by proper using its tools such as monetary and fiscal policies. Besides, corporations and people must also cooperate with government to prevent financial crisis happen.

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