US Institutions in the Global Financial Crisis

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This essay discusses about the global financial crisis that struck United States. It will look at what measures did US government took to protect these financial institutions. Then it will analyze shareholder and stakeholder models of corporate social responsibility, then relate this theory with the situation. Next it will discuss whether US government's action could be justified from either or both of these models and it will talk about the short and long term consequences of government intervention. And in conclusion it will discuss whether actions taken by US government is best for society or not. The global financial crisis all started back in 1977, when Community Reinvestment Act was passed by 95th US Congress and signed into law by president Jimmy Carter (Busy Times, 2008). It was designed to encourage commercial banks to meet the needs of borrowers in all segments of the communities, including low-income neighborhoods (Busy Times, 2008) Then initially led by very low interest rate regime during Alan Greenspan's era, 2000 - 2006, it allows homebuyers to take up mortgage with low interest as it allow financial institution to generate income growth, and one of it is subprime lending, practice of making loans to borrower who do not qualify for market interest rates of traditional housing mortgages cause it had problems with their credit history or the credibility to prove they had enough income to support the loan payment (Busy Times, 2008). Through this, borrowers with bad credit history were able to get a mortgage loan, even borrowers with no income, job and ability to repay; consequently it decreases the lending standards, as shown below (Busy Times, 2008). With this situation, 2nd tier institutions were lending money to homeowners, and then securitize the assets and sell it to major US financial institutions including many investment banks, and those investment banks sold it to investors (Busy Times, 2008). This cycle allow bank to earn extra income for the sale, consequently this let to a sharp rise in household debt, graph 1 (Busy Times, 2008). At first it was not a problem cause house price kept growing for years, graph 2, thus borrower could not repay the loan, bank could always foreclose mortgage and sell the collateral (the house) at a higher price (Busy Times, 2008). <- Graph 1 - Household Debts (APRA, 2008) Graph 2 - House Price (APRA, 2008) -> But as housing affordability fell, housing prices rose more than disposable income, this meant people were not up to meet the test of subprime, therefore bank's income would fall due to lower volume of loans, but there were unrealistic expectations of asset growth in housing (Busy Times, 2008). Housing prices starts to fall, and more and more people defaulted, so now there are more houses in the market than buyers, which causes housing prices to fall even further (Busy Times, 2008), which mark the start of the global financial crisis. Global Financial Crisis initially started in United States, and United States being a super power country, brings a huge impact to the rest of the financial world. Trying to fix this, United States government responded by providing some solutions, one of it is Troubled Asset Relief Program (TARP). The Troubled Asset Relief Program (TARP) set up under the Emergency Economic Stabilization Act, 2008 (Ghosh, S. & Mohamed, S., 2010), authorized the US Treasury Secretary a total of $700 billion to establish TARP (Ghosh, S. & Mohamed, S., 2010). "TARP provides wide raging powers to US Treasury secretary to purchase, manage and sell troubled assets held by financial institutions, and to sell or enter into securities, loans, repurchase transaction or other financial transactions with respect to any troubled asset purchased under the Act" (Ghosh, S. & Mohamed, S., 2010),. Under TARP, bank, thrifts, credit unions, broker dealers and insurance companies are deemed as financial institutions, but central bank or institution that is owned by foreign government is not deemed as financial institution (Ghosh, S. & Mohamed, S., 2010),. And as for troubled assets, it include "residential, commercial mortgages, securities, obligations and other instruments based on related to such mortgages, in each case originated or issued on or prior to March 14, 2008 as defined by the Act" (Ghosh, S. & Mohamed, S., 2010). TARP was originally intended to be a lending programme and one that would increase liquidity by encouraging the flow of credit between the banks and from banks to customers (US treasury, 2008a). The idea was to enable federal government to obtain up to US$700 billion of illiquid mortgage backed securities (MBS) and assets backed securities (ABS) and thereby lubricate secondary mortgage markets (US Treasury, 2008a). TARP was also design to minimize losses of financial institutions owing the "toxic" assets and thereby, inducing credit growth (Ghosh, S. & Mohamed, S., 2010), Economic Stabilization Act, 2008, states the objective of TARP, is to provide stability to US financial system, preventing disruption in economy at large and financial system and protect US taxpayer (Ghosh, S. & Mohamed, S., 2010), The Act also offers setting up of Troubled Assets Insurance Financing Fund (TAIFF), the purpose is providing financial institutions the chance to purchase insurance from government to guarantee their troubled assets (Ghosh, S. & Mohamed, S., 2010). But conversely, in about five weeks, Treasury was suppose to buy those toxic assets off the balance sheets of the bank and financial institutions, but instead the Treasury bought non voting preferred stock from banks and institutions through investing TARP funds in them (US Treasury, 2008d). Cause of that, TARP has failed to "ensure liquidity, repair confidence, build trusts in the banking system, redress the issues of encouraging lending to homeowners, counter massive foreclosures and contraction in housing market and stop house prices from spiraling downwards" (Congress Oversight Panel Report, 2009c; Barr, 2008; McIntyre, 2009). "The first tranche of $250 billion TARP money was used to pump in $167 billion in 87 banks in exchange for preferred stock and warrants" (US Treasury, 2008e). Next it went to AIG, about $40 billion (US Treasury, 2008f), then to Citibank, about $45 billion in exchange for preferred stocks and warrants (Ericson et al., 2009). As in Wall Street Journal, it discuss that U.S. government made a bail out as of American International Group Inc. (AIG) as it injects $85 billion to the firm, this show the intensity of its concerns about the danger of AIG collapsing to the financial system (Kartnitschnig, M. et a, 2008). The decision was difficult one, as "federal government had been strongly resisting overtures from AIG for an emergency loan or intervention that would prevent the insurer from falling into bankruptcy" (Kartnitschnig, M. et a, 2008). Cause just a week before, government decided not to intervene to help Lehman Brothers Holdings Inc, as a result it went bankruptcy, but this time government decided AIG was truly too big to fail (Kartnitschnig, M. et a, 2008). "U.S. government also took over mortgage lending giants Fannie Mae and Freddie Mac as the teetered near collapse", another Wall Street giants, Merrill Lynch & Co agreed to self it self to the Bank of America Corp (Kartnitschnig, M. et a, 2008). In the end, U.S. negotiators negotiate a proposal that could help both sides, which the Federal will lend $85 billion to AIG and in return U.S. government would be entitled to 79.9% equity stakes in form of warrants (equity participation notes) and the two year loan will have Libor (London interbank offered rate) + 8.5% interest rate (Kartnitschnig, M. et a, 2008). Shareholder theory suggest that business are just arrangements by which shareholders advance capital to managers to be utilized for specified ends and for receive an ownership interest in the venture (Beauchamp et al, 2009,p.66). In this perspective, managers perform as agent for shareholders, though bound by agency relationship to do so exclusively for the purposes of their shareholder principle (Beauchamp et al, 2009, p.66). This fiduciary relationship implies that managers does not have the obligation to expand business resources in ways that are not authorized by shareholders, despite presence of societal benefits from doing so (Beauchamp et al, 2009, p.66). However, both shareholders and managers are free to use their private funds for charitable or socially beneficial project, but when performing as officers of the business, managers have the duty not to divert business resources away from the intention of the shareholders, and managers, him or herself are obligated to follow legal directions of the shareholders and are required to maximize shareholder financial returns (Beauchamp et al, 2009, p.66). Nevertheless, it does not state that managers to ignore ethical constraints in pursuit of profits, rather it make certain managers are compelled to pursue profits by all legal and non deceptive means (Beauchamp et al, 2009,p.66) Adam Smiths invisible hand argument state the market is efficient if everyone is allowed to pursue Conversely, shareholder theory has been looked from two different perspectives, which are consequentialist and deontological. Consequentialist, argue that businesses or businesspersons does not have any social responsibilities, other than to legally and honestly maximize profits of the firms (Beauchamp et al, 2009,p.67). Deontological side; argue that based on observation, shareholders transfer their funds to business managers on the provision, those funds are used on their wishes (Beauchamp et al, 2009,p.67). If managers accepted those funds on that specific circumstance, they are not allowed to spend it to accomplish social goals, other than authorized by shareholders, and if they did without authorization, they would be violating their agreement and spending other people's money without their concern (Beauchamp et al, 2009,p.67). Stakeholder theory, "a theory of organizational management and business ethics that addresses morals and values in managing an organization" (Philip et al, 2003), as in the definition above, the theory itself is divided into two parts, organizational management and business ethics. The organizational management side is known as Empirical theory of management and the business ethics as Normative theory of business ethics. As in this essay, it will focus on the Normative theory of business ethics. Empirical theory of management just discuss about effective managements are required for balancing consideration of and attention to the legitimate interest of all stakeholders, anyone who has stake on firm (Beauchamp et al, 2009,p.69). Normative theory in the other hand, argue, "regardless whether stakeholder management leads to improved financial performance, managers should manage the business for the benefit of all stakeholders" (Beauchamp et al, 2009,p.69). It views firms not as a mechanism for increasing stockholders returns, rather as a vehicle managing stakeholder interests and sees management as having a fiduciary relationship not just to stockholders, but all stakeholders (Beauchamp et al, 2009,p.69). As a result, it guides management to give equal interest to all stakeholder (Beauchamp et al, 2009,p.70), therefore in this normative form, stakeholder theory imply business have true social responsibilities (Beauchamp et al, 2009,p.70) But normative theory and empirical theory agree on one thing, the best way to enhance the stakeholder's return on their investment is to pay attention to the legitimate interests of all stakeholders (Beauchamp et al, 2009,p.69). "Stakeholder theory holds that management's fundamental obligation is not to maximize the firm's financial success, but to ensure its survival by balancing the conflicting claims of multiple stakeholders" (Beauchamp et al, 2009,p.69). Meeting this obligation, act accordance to two of stakeholder management must be done, which are, principal of corporate legitimacy and stakeholder fiduciary duty. Principle of corporate legitimacy, "the corporation should be managed for the benefit of its stakeholders: its customers, suppliers, owners, employees, and the local communities"(Beauchamp et al, 2009,p.70). "The rights of these groups must be ensured and, further, the group must participate, in some sense, in decisions that substantially affect their welfare" (Beauchamp et al, 2009,p.70) Stakeholder fiduciary duty, "management bears a fiduciary relationship to stakeholders and to the corporation as an abstract entity, which must act in the interests of the stakeholders as their agent, and it must act in the interests of the corporation to ensure the survival of the firm, safeguarding the long term stakes of each group"(Beauchamp et al, 2009,p.70). As to shareholder theory, the actions of the corporations comply with this theory, as corporations look for sources of income through securitization process. The cycle begin with institutions lending money to homeowner, then securitizing the assets and selling it to major U.S. financial institutions including many investment banks, and finally those investment sell it to investors (Beauchamp et al, 2009, p.66). This allow bank to earn extra income for sale, and generate a massive income (Beauchamp et al, 2009, p.66). By doing so, it comply with the shareholder theory, as it argue that businesses or businesspersons does not have any social responsibilities, other than to legally and honestly maximize profits of the firms, but this theory is best for short term (Beauchamp et al, 2009, p.67). Since the theory emphasize on best to maximize profit, banks lower their standards of lending, not thinking thoroughly the consequences, banks were able to lend more and to securitize more, which can generate more income (Beauchamp et al, 2009, p.66). At first it was not a problem at all, as if borrower could not repay loan, bank could always foreclose mortgage and sell collateral (house) at a higher price, cause house price kept growing for years (Beauchamp et al, 2009, p.67). But as years past by, housing affordability fell, since supply is less then demand, to be able to equalize it, price need to be put up (Beauchamp et al, 2009, p.66). As housing price rose more than disposable income, more people were not up to meet the test of subprime, for that reason bank's income would fall due to lower volume of loans (Beauchamp et al, 2009, p.67). But due to unrealistic expectations of asset growth in housing, housing prices start to fall and more and more people defaulted, so now there is more supply than demand (Beauchamp et al, 2009, p.67). To equalize this, price needs to be put down, soon as housing prices fall down, it marked the start of the global financial crisis. Fiduciary duty of a shareholder theory is to maximize their income for their shareholder, and neglecting other factors (Beauchamp et al, 2009, p.67). But in stakeholder theory, the fiduciary duty is to act in the interest of the stakeholder and must act in the interest of the corporations to ensure survival of the firm, safeguarding long-term stakes of each group and it holds that management's fundamental obligation is not to maximize the firm's financial success, but to ensure its survival by balancing the conflicting claims of multiple stakeholders (Beauchamp et al, 2009, p.67). It also view firms not as mechanism for increasing stockholders returns, rather as a vehicle managing stakeholder interests and sees management as having a fiduciary relationship not just to stockholders, but all stakeholders (Beauchamp et al, 2009, p.66). As a result, it guides management to give equal interest to all stakeholder, therefore in this normative form, stakeholder theory imply business have true social responsibilities (Beauchamp et al, 2009, p.67). It also suggested, corporation should be managed for the benefit of its stakeholders: its customers, suppliers, owners, employees, and the local communities"(Beauchamp et al, 2009,p.70). "The rights of these groups must be ensured and, further, the group must participate, in some sense, in decisions that substantially affect their welfare" (Beauchamp et al, 2009,p.69). As what the U.S. government does, it complies with this theory. U.S. government intervenes with this situation, to help stabilize the financial system, cause if not, the financial crisis could have a worsen affect and everyone would suffer more. The U.S. government intervenes through TARP (Troubled Asset Relief Program). Those funds in TARP were used to pump in $167 billion in 87 banks in exchange for preferred stock and warrants (US Treasury, 2008e). Then to AIG, $40 billion (US Treasury 2008,f) then Citibank, $45 billion in exchange for preferred stocks and warrants (Ericson et al., 2009). U.S. government also took over mortgage lending giants Fannie Mae and Freddie Mac as the teetered near collapse (Kartnitschnig, M. et al, 2008). The U.S. government also offers setting up of Troubled Assets Insurance Financing Fund (TAIFF), to help financial institutions have a chance to purchase insurance from government to guarantee their troubled assets (Ghosh, S. & Mohamed, S., 2010). By those actions, it could show that US government is complying with the stakeholder theory. As the US government intervenes with those funds, it shows an "act in interest of the corporations to ensure survival of the firm, safeguarding long term stakes of each group, and holds that management's fundamental obligation not to maximize the firm's financial success, but to ensure its survival by balancing the conflicting claims of multiple stakeholder (Kartnitschnig, M. et al, 2008). Although the fundamental obligation was not to maximize firms financial success, but there fiduciary duty also stated to act in the interest of shareholder, and shareholder does want returns on their investment. Therefore the U.S. lend the $85 billion to AIG, but in return to U.S. government, U.S. government would be entitled to 79.9 equity stakes in form of warrants and 2 year loan will have Libor + 8.5% interest rate (Kartnitschnig, M. et a, 2008). This show both short term and long term consequences of this government intervention generate a positive outcome, as for the short term, US government sustain those companies from bankruptcy, so it does not worsen the financial crisis, hurting more people in their financial situation. For the long term, the US government benefit from the interest rate that they get from those banks. But from bailouts, it could also bring "negative short-term effects, such as higher taxes, bigger government and lower salaries" (Taylor, M., 2007). As well as for long term, it could bring negative effects, such as "government abandoning fiscal discipline, asset bubble or inflation could occur and commodities bubble driven by negative real interest rate" (Peng, B.,2008). In conclusion, this essay has discussed about the global financial crisis that struck United States. It discussed the measures that US government took to protect these financial institutions, such as TARP or TAIFF. It also have discussed and related shareholder and stakeholder models of corporate social responsibility with the Global Financial Crisis, by justifying US government action from either of these models and analyzing the short and long term consequences of the government intervention, and the conclusion that the action that US government has taken for this current situation was best for society, as if US government have not taken those steps. It could have worsen the financial crisis and have a greater impact to others countries, just like a domino affects. Cause United States is a super power country, which have a lot of impacts to other countries in this world. By taking those steps, it was best for this society.
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