The World Has Witnessed Financial Institutions Casualties - Coursework Example

Table of Content Title Page(s) Introduction 2-3 Freddie Mac 4-5 Why was Freddie Mac In Trouble 5-6 Lehman Brothers 6-8 Causes of Collapse 8-10 Lessons From Global Financial Crisis 10-11 Online References 12-13 Introduction The global economic crisis, brewing for a while, started to show off its effects in the middle of 2007 and into 2008. Around the world, stock markets fell, large financial institutions collapsed or were bought out and governments in even the wealthiest nations had to come up with rescue packages to bail out their financial systems (Shah 2009). In September, 2008, the crisis emerged with the failure, merger or receivership of several large United States based financial firms and spread with the insolvency of additional companies, governments in Europe, recession and declining stock market prices around the globe. The crisis emerged as a result of a combination of reasons. Beginning with failures caused by misapplication of risk controls for bad debts, collateralization of debt insurance and fraud, large financial institutions in the United States and Europe faced a credit crisis and a general slowdown of economic activity. The crisis rapidly developed and spread into an economic shock resulting in a number of European bank failures, decline in many stock indexes and large reduction in in the market value of equities and commodities. As a result of these events, several companies, some of them government-sponsored entreprises were nationalised whiles others were either taken over by other companies and corporations or in worst cases simply collapsed. The Federal Home Loan Mortgage Corporation popularly known as Freddie Mac and Lehman Brothers are two examples of corporations which were nationalised or collapsed recpectively. The report examines the the activities of Feddie Mac and Lehman Brothers prior to crisis. It will also analyse the impact of nationalisation or in the case of Lehman Brothers, it’s collapse and how it affected stakeholders in the financial markets in the USA, Australia and globally. It will also assess whether lessons have been learnt from these case studies thus placing the markets in a better position to prevent any crisis of this magnitude from occuring. Freddie Mac – Federal Home Loan Mortgage Corporation: One of America’s biggest buyers of home mortgages, it is a stockholder-owned Corporation chartered by Congress in 1970 to keep money flowing to mortgage lenders in support of home ownership and rental housing. Thus, it was created to expand the secondary market for mortgages in the United States. It did this by buying mortgages on the secondary market, pooled them and sold them as mortgage-backed securities to investors on the open market. One of several Government-Sponsored Enterprises, it is privately owned but publicly chartered. Its primary method of making money is by charging a guarantee fee on loans that it has purchased and securitized into mortgage-backed securities bond. Investors of Freddie Mac’s Mortgage-Backed Securities are willing to let Freddie Mac keep this fees in exchange for assuming the credit risk, that is Freddie Mac’s guarantee that the principal and interest on the underlying loan will be paid back regardless of whether the borrower actually repays. In 2007, Freddie Mac had a total equity of $26.724 billion with a net income of $3.094 billion and total assets of $794.368 billion. It also had in the same year made revenue of $43.104 billion. Together with its larger rival, Fannie Mae, their roles had also been controversial due to their unusual status. As government-chartered entities, they were able to borrow money at lower rates than their competitors as most investors took for granted that their operation were implicitly guaranteed by the federal government. At the same time, as publicly traded companies, they sought to maximize their revenues and returns. Critics questioned their accounting which was said to have been manipulated by executives to justify their large and growing compensation. Freddie Mac had traditionally backed what has been called the “plain vanilla” end of the mortgage market (New York Times April, 2009) concentrating on the 30-year fixed rate loans. But as the mortgage market exploded in the middle of the decade, they lost market share to the more aggressive lenders. Why Was Freddie Mac In Trouble? Although Moody’s, a financial research and analysis company which specialized on commercial and government entities gave Freddie Mac’s preferred stock on investment grading of A1, it together with larger rival Fannie Mae made billions in losses as the US housing market saw a big increase in defaults and repossession. The corporation lost more than $3 billion between April and June of 2008 alone which resulted in a sharp fall in its share value. To cover these loses, they tried to raise funds but investors feared they may not be able to raise enough to cover their liabilities. This meant they had to pay out if ordinary homeowners could not pay back their home loans. This prompted the Federal Government in September 2008 to announced measures which would put Freddie Mac and Fannie Mae under the conservatorship of the Federal Home Financing Agency (FHFA). This was in effect an attempt by the government to nationalize these corporations. The former chairman of the US Federal Reserve had earlier hinted this and had backed the concept in principle once commenting that “it may be necessary to temporarily nationalize some banks in order to facilitate a swift and orderly restructuring” (Guha and Luce 2009) adding that temporary government ownership will “allow the government to transfer toxic assets to a bad bank without the problem of how to price them”. Nationalisation is the art of taking an industry or assets into the public ownership of a national government. The measure would put the corporation under government control. Lehman Brothers Lehman Brothers was a global financial services firm which until it filed for bankruptcy in 2008, did business in investment banking, equity and fixed income sales, research and trading, investment management, private equity and private banking. Founded in 1850 by cotton brokers, Henry Lehman, Emanuel Lehman and Mayer Lehman in Montgomery Alabama, it was moved to New York after the civil war and became one of Wall Street investment giants. In September 2008, it filed for Chapter 11 bankruptcy protection after huge loses in the mortgage market and the loss of investor confidence crippled it as it was unable to find a buyer. The filing marked the largest bankruptcy in US history. In the same month of September 2008, the British bank Barclays announced its agreement under to regulatory approval, to purchase Lehman’s North America investment banking and trading division along with its New York headquarters building . Nomura also announced its interest in acquiring the Lehman Brothers franchise in the Asia Pacific region which included Japan, Hong Kong and Australia. It also announced its interest in the investment banking and equities businesses in Europe and the Middle East. Lehman’s slow collapse began as the mortgage market crisis unfolded in the summer of 2007 when its stock began to fall from a peak of $82 a share. The fears were based on the fact that the firm was a major player in the market for sub prime and prime mortgages and that as the smallest of the major Wall Street firms, it faced a larger risk that large loses could be fatal. In June, 2008, Lehman announced a second-quarter loss of $2.8 billion, far higher than analysts have expected. Although it sought to raise $6 billion in fresh capital for investors, this effort proved unsuccessful as the situation became difficult after the government announced the takeover of Fannie Mae and Freddie Mac. Lehman’s stocks plunged further as the markets wondered whether the move to save those mortgage giants made it less likely that Lehman might be bailed out. The announcement of Lehman Brothers’ demise sent shockwaves across the financial world. In Australia, the Securities Exchange (ASX) suspended Lehman’s Australian subsidiary as a market participant after clearing houses terminated their contracts with the firm. In the United Kingdom, the investment bank went into administration with PriceWaterhouse Coopers appointed as administrators. Whiles in Japan, Lehman Brothers Japan Inc. and its holding company filed for civil re-organisation in the Tokyo court. There are experts who are of the opinion that the US government was wrong for not bailing out Lehman Brothers as it did with Fannie Mae and Freddie Mac. In the United Kingdom, 5,000 staff of the now defunct Lehman Brothers lost their jobs. Many experts, particularly those in the United States expected the Federal Government to rescue the stricken just as it had organised the sale of Bears Stearns to JP Morgan six months earlier (Seib 2008) and this set off a chain of reaction around the world. The bank’s default on $165 billion unsecured debt hit investors with an estimated $120 billion in loses. The credit default swap (CDS) of which Lehman was a major player dried up. Thus in short, Lehman Brothers collapsed because other banks refused to trade with it. Without the ability to trade and without investors prepared to bet on its long term viability, Lehman Brothers simply had no business. Causes Of Collapse The cause of collapse of Freddie Mac and Lehman Brothers is linked to the sub-prime market. So what exactly is a sub-prime loan? A sub-prime loan is a loan given to borrowers that are considered more risky or less likely to be able to make loan payments in relation to high quality borrowers because of problems with their credit history (Waring 2007). They specialized in lending to borrowers with poor credit histories and poor documentation of their income who were shunned by the big players like the big banks. Some of these lenders gave out loans which were over and above what customers could afford when it came to making payments. This business end of the industry proved to be successful, particularly for the banks who earned a fee for each mortgage they sold. They urged mortgage brokers to sell more and more of these mortgages. The downside of the sub-prime mortgage or loans were that it was an Adjustable Rate Mortgage (ARM) as their payment were fixed after two years after which it became higher and dependent on federal or national interest rate which also rose substantially. And as adjustable rate mortgages began to reset at higher rates, mortgage delinquencies soared. Securities backed with sub-prime mortgage widely held by financial firms lost most of their value. In the USA, this led to a large decline in the capital of many banks and USA government sponsored enterprises tightening credit around the world. Thus the current crisis is triggered by a dramatic rise in “mortgage delinquencies” and the foreclosures that resulted from these delinquencies, especially in the United States but with major adverse consequences for banks and financial markets around the world. However, whiles both companies fell victims of the same crush associated with the sub- prime market, Freddie Mac received massive capital injection under conservatorship or nationalization whiles Lehman Brothers was left to collapse. Many experts are of the opinion that the US government should have intervened in the matter. The key factor to the decision lied in the way both companies operated. Freddie Mac was a government-sponsored enterprise which made it a private enterprise with a public charter. It had government backing in such event as the one which caused the global financial crisis. The US treasury at the time of the crisis had exceeded its limit of taxpayer funds it was willing to gamble on propping up failing investment banks having earlier on bailed out Bears Stearns. If they had failed to prop up Freddie Mac, the mortgage market would have collapsed and hundreds of banks around the world that had invested in the US property market would have suffered huge loses. Secondly, because Lehman brothers like other trading houses had little direct connection with retail markets and ordinary homeowners, it was easy to let go bust without causing the systemic risked posed if Freddie Mac or indeed Fannie Mae were allowed to go bust. Meraiah Foley (2009) commented in the New York Times that the Australian economy, once considered a relatively safe haven was heading to a steep downturn in 2009 in part because of slower than expected growth in China. 300,000 jobs would be lost and corporate profits were going to be cut in half. This came against the backdrop of relative calm in an economy which had long regarded itself as relatively immune to the financial problems affecting the United States and Europe. Lessons From The Global Financial Crisis With the International Monetary Fund growth forecast of the world set at -1.0 to -0.5 in 2009 alone, there is no doubt the world has been directly hit by a crisis which was pretty much a US problem. Currently the global economy is slowing down rapidly with a further growth forecast of 1.5% to 2.5% in 2010 (IMF 2009). With unemployment set to rise this year as more companies struggle to keep up with their output of products with no corresponding demand, the IMF estimate that loses incurred by the world financial sector is $2 trillion (IMF 2009). As a result of the financial crisis, important lessons must be learnt in order to prevent another financial crisis of such magnitude from occurring. The lessons to be learnt apply more to the world’s advanced economies. For the United States and other mature industrial powers, this crisis provides an opportunity to improve the competitive and democratic capitalist model. For the United States, there needs to be a restoration of adequate liquidity through well- targeted infusion of cash, credit and the guarantees for financial institutions and their transaction. Secondly, that it needs to take a strong look at the sub-prime money market which was the major trigger of the crisis (Kiedel 2008). There also the need for a common set of accounting principles across board and borders. In global markets, one cannot have abiding by different standards of accounting and disclosure simply because they are headquartered in different countries (Schwarzman 2008). Following up on this, the financial regulatory regime in the world’s major markets needs to be structured along the same lines. Thirdly, there need to be full transparency for financial statements. In addition, full disclosure of financial statements should be made to the regulator. No regulator can do its job of assessing risk and systemic soundness if large parts of the financial markets are invisible to it. A regulator must be able to monitor derivatives including a $60 trillion in credit default swap. The regulator must have oversight over all financial institutions which participate in the markets regardless of their charter, location or legal status. With the benefit of hindsight, it is clear that the crisis has presented important issues for experts, policy makers, economists and politicians to think. Vital lessons have been learnt, never to repeat itself again. Online References Foley, Meraiah (2009) A Gloomy Forecast For Australian Economy In 2009 http://www.nytimes.com/2009/01/20/business/worldbusiness/20australia.html?fta=y 28th April 2009 Global Financial Crisis of 2008-2009 http://en.wikipedia.org/wiki/Global_financial_crisis_of_2008%E2%80%932009 27th April 2009 Guha, Krishna and Luce, Edward (18th February 2009) Greenspan Backs Bank Nationalisation. http://www.ft.com/cms/s/O/e31ocbf6-fd4e-11dd-a103-000077607658.html 27th April 2009 Shah, Anup (2009)Global Financial Crisis http://www.globalissues.org/article/768/global-financial-crisis 27th April 2009 Nationalisation http://en.wikipedia.org/wiki/nationalisation 25th April 2009 Freddie Mac (Federal Home Loan Mortgage Corporation) http://en.wikipedia.org/wiki/Freddie_Mac 26th April 2009 Government Sponsored Entreprises http://en.wikipedia.org/wiki/Government_sponsored_entreprise 26th April 2009 Federal Home Finance Agency http://en.wikipedia.org/wiki/Federal_Home_Loan_Corporation#cite_note-FHFA-Conservatorship-2008-09-07-1 26th April 2009 Freddie Mac http://www.freddiemac.com/corporate/about_freddie.html 26th April 2009 http://topics.nytimes.com/topics/news/business/companies/freddie_mac/index.html?inline=nyt-org 27th April 2009 http://news.bbc.co.uk/1/hi/business/7502310.stm 27th April 2009 http://www.freddiemac.com/investors/er/financial-history.html 27th April 2009 http://en.wikipedia.org/wiki/Lehman_Brothers 27th April 2009 Seib, Christine (2008) Fallout From Lehman Brothers Collapse Still Spreading. (18th December 2008) http://business.timesonline.co.uk/tol/business/industry_sectors/banking_and_finance/article5332752.ece 28th April 2009 http://www.guardian.co.uk/business/2008/sep/15/lehmanbrothers.marketturmoil 28th April 2009 Waring, David (2007) A Simple Explanation Of Sub-Prime Crisis Part 1 http://www.informedtrades.com/2699-simple-explanation-subprime-crisis-part-1-a.html 28th April 2009 Strauss-Kahn, Dominique (2009) The Global Financial Crisis: Preliminary Lessons. http://www.imf.org/external/np/speeches/2009/pdf/032509.pdf 28th April 2009 Kiedel, Albert (2008) Global Financial Crisis : Lessons For The United States And China. http://www.carnegieendowment.org/publications/index.cfm?fa=view&id=22329&prog=zch 28th April 2009 Schwarzman, Stephen (2008) Some Lessons Of The Financial Crisis: Seven Principles To Guide Reform Here And Abroad. http://online.wsj.com/article/SB122576100620095567.html 28th April 2009 Read More