Collapse of the banks in the United States Essay

Abstract

Most people believe that the banking industry is impregnable to the changing financial times. Many of us believe that the banks have enough financial muscle to withstand the global economic meltdown. But, alas, the banking industry is taking a shellacking from the economic malaise that is currently afflicting the United States economy. How did the banks sink to levels thought of as nearly impossible? Better yet, how did they get into this situation; what caused the banks in the United States to collapse?

United States Banks: On the brink or toppled over?

            It is an understatement that the economy of the United States is in very dire straits. News about the continuing effects of the U.S. meltdown and the effects of this situation are still being debated upon, not that the fact that the malaise will continue. That is a foregone conclusion. What is being discussed is how bad the crunch will be and wide the swath of the economic slowdown will have on the rest of the global economies.

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            The banking sector seems to be the hardest hit among the sectors in the economy. But banks are supposed to have large amounts of financial muscle at their disposal right? So how did the banks fall off the precipice of the United States economy? Were there any signs that the banks would be in such a situation? Were they born by circumstances out of their control, or were they made by the acts and conduct of man?

What happened?

            Many are still of the belief that the current financial situation in the United States will continue to affect many parts of the world, in spite the fact that the United States House of Representatives enacted a bailout plan designed to cushion the effects of the present crisis (Mahmoud Al-Qassas, 2008). The plan calls for the acquisition of the so-called “bad debts”, or assets and debts from other banks for a lump sum of $ 700 billion dollars. According to Arab Banks Union chairman Dr. Fuad Shaker, one of the main drivers of the crisis in the financial sector was the significant rise in the mortgages via the sub prime market in the United States. These were in part dependent on the prices of the real estate market (Shaker, 2008).

            Some critics of the administration point an accusing finger at Treasury Secretary Ron Paulson for the collapse of the banks in the United States. They claim the lack of expertise of Paulson in banking practices, as differentiated from investment banking, put the situation of the banks in a far worse situation than it should have been. Cronyism, they point out, was evident in the disposition of the bail out funds that was appropriated for the financial markets. Paulson, they state, allocated $125 billion in some of the largest banks, including $ 10 billion for Goldman Sachs, where Paulson was formerly connected (F. William Engdahl, 2008).

            They claim that the act of Paulson was an act of cronyism in the fact that the equity, or the share that the government acquired for that amount, totaled about $ 62.5 billion, the amount that a private investor would have to disburse. But nobody said anything, as Paulson imposed on Congress that he be given sole authority to disburse these funds, amounting to more than $ 700 billion, at his own discretion (Engdahl, 2008). But separating politics and the actual issue is a difficult task. Let us strive to see the issue as supported by events and facts.

            One of the more notable collapses was that of the investment bank mogul Bear Stearns (David Lynch and John Waggoner, 2008). The collapse of the investment was considered as a large warning signal to United States financial managers that there was something terribly remiss in the economy. In conjunction with the statement of Dr. Shaker, the first element in the collapse of Bear was the crisis in the sub prime housing mortgage market. This contagion infected and spread through the credit market in the United States (Lynch and Waggoner, 2008).

            As the real estate market was tied to the prices that were prevailing in the agora, the downward spiral of those prices affected the sub prime mortgages in the United States. As a result, the incidence of homeowners not being able to finance their mortgages began to increase, eventually defaulting on many of their payments in the process. This triggered the move of the United States’ central bank to intervene into the scene before a loss of trust would occur. One of the signs then that the market was in serious trouble was when the investment bank sold out a $ 2 a share, 93 percent off its market value on the last trading day at Wall Street (Lynch and Waggoner, 2008).

            Why was the downturn of real estate prices affecting the financial sector in a negative way? Banks primarily derived their income from the rising prices of the assets in the real estate market. As the prices of the market declines, so did the income that the banks derived from this activity. As the economic machine of the United States slowly ground to a halt, so did the activity in the housing sector (Al-Qassas, 2008).

            As the incomes of many Americans began to nose dive, they started to fall short of their commitments in the payment of their amortizations to the banks (Al-Qassas, 2008). This was because as the economy of the United States started to be inactive, the people who borrowed money from the banks lost their jobs, in the process lacked the finances to pay off their debts. For the banks, they became stuck with these unprofitable assets, as they could not sell off the assets. It was because the loan values that the assets were given to the lenders were worth far less than the actual value of the asset (Al-Qassas, 2008).

            World Bank economic analyst Ibrahim Al-Badawi, expressing his personal findings apart from the findings of the global banking body, said that financial entities acquire these securities with the debts of real estate assets as a guarantee (Al-Badawi, 2008). Badawi states that the securities are sold over and over again as long as there are buyers for these securities. In effect, according to Badawi, the activity is not new in the realm of the financial transactions. What must be noted is that these securities are sold many times over without any regulation and control (Al-Badawi, 2008).

            The exigency that is currently besetting the United States banking sector has in effect beaten these assets to a pulp and has shaken the global finance markets. Yet the elements that have given rise to the current crisis is again, not new; in fact, they are descriptive of the financial shocks that the banking and financial markets in recent history. One law that the banking sector in the United States should have observed is that the credit being extended to borrowers should not be extended under any circumstance, and the credit should be used a stimulus to initiate productive endeavors (Tony Makin, 2008).

            Banks are said to play a central factor in any financial institution, be it local or in the global perspective. In recent years, the role that financial markets play in the global financial scheme has been increasing in importance. Inclusive of the sectors in the financial markets are concerns that deal with debt, equity and the foreign exchange markets. As the role of the financial markets increased, disruptions in these markets are amplified. In this age where most of the financial markets across the globe are assimilated, the disruptions in one market can be easily spread to other markets (Makin, 2008).

            In the United States, the Federal Reserve is working feverishly to cope with the disruptions caused by the collapse in the banking sector. What the Fed can hope for is for these efforts to pay off in the form of a recovered economy, specifically that the public will regain their trust and faith in the banking sector. What is the most reprehensible thing that the Fed can expect? It is for the “illness” that the banks in the United States are having to spread to other banks, financial markets and other economies across the borders of the United States (Lynch and Waggoner, 2008).

            In his testimony before the House of Representatives Committee on Oversight and Government Reform, Luigi Zingales, a faculty Research Fellow at the National Bureau of Economic Research (University of Chicago Graduate School of Business, 2008), discusses yet another banking institution’s collapse due to the economic crisis in the United States, that of investment giant Lehman Brothers. In his testimony, Zingales says that the current crunch in the U.S. economy exceeds that of the Great Depression in the 1930’s. According to Zingales, the conception of the current crisis, and the death of Lehman Brothers, began with several factors: a dearth in the practice transparent practices, woeful regulation policies and market vainglory (Luigi Zingales, 2008). How did each play a factor in the downfall of the system?

Market Pride

The housing boom before the onset of the crisis exhibited a long period of depressed interest rates that led in turn to an unusual increase in housing prices. From the period of March 1997 to June 2006, the national standard for the prices of houses in the United States, the Case and Shiller index, showed that aside for a two month time frame, housing prices went up. In the same time frame, the increases in housing prices went up 12.4 percent on the average. The illusion created here is that housing prices will continue to be on the uptake (Zingales, 2008).

It is interesting to note that in this time of increasing housing rates, levels for delinquency in mortgage payments were very low. This is reasoned out that during this time, homeowners did everything possible to pay their amortizations even if the rates went up. Also, there was the start of creative lending structures for new homeowners, in the light of the optimal positions that the banks were in. These led to the decay in the lending practices of the banks (Zingales, 2008).

The relaxing of the stringent policies that accompanied the lending practice of the banks was worsened by the practice of securitization, i.e. banks grouped mortgages so that they can sell the lot in wholesale. In this practice, the mortgages that were older usually held the safest net for return. But since the mortgages were sold in batches, investigation into the credit history of the mortgages could not be conducted. In effect, the financial institutions failed to conduct due diligence on the assets that they were buying (Zingales, 2008).

Woeful Regulations

The incidence of having conflicting regulations in the housing sector created an illusion of large demands in that sector. Freddie Mac and Fanny Mae, two government sponsored entities (GSE’s) were allowed to invest in the abovementioned securities, in disregard of the charter they were given by the Department of Housing and Urban Development, or did they? In fact, the Housing Department even encouraged the two to allot funds to buy these securities. Another problem that led to the downfall of the bank was the dearth in transparency in the policies of the banks (Zingales, 2008).

In a span of ten years the rates for “credit default swaps” grew in a deregulated market from nil to almost $ 44 trillion, or double the size of the value of Wall Street. The issue of CDS also claimed another “victim” in American Investment Group, or AIG. Like AIG, most large commercial financial institutions are exceedingly exposed to issues in CDS. Most of the larger banks have hedged, or protected, stations in their investments making their risk exposure very minimal. But if a prominent company falls, the smaller players in the market will rush to acquire means to protect themselves, mainly buying insurance (Zingales, 2008).

Since there is a limited amount of insurance in the market, the rates of that insurance will likely increase dramatically. In the context of the housing contagion, homeowners who cannot afford that insurance will be likely to default on their payments. Hence, the event of the triggering of the defaults will result in foreclosures and in lost income for the banks. That in essence gave rise to the real estate crisis in the United States (Zingales, 2008).

What can be seen?

            In the opinion of Dr. Shaker, the ongoing financial malaise in the United States will force the methodologies that the banks in the United States to be improved, and others to be scrapped altogether. He advises the institutions carrying the reforms on the financial market to address the ways that real estate credit is issued, how it is facilitated and the manner by which banks purchase these assets. He also advises authorities to inquire from the bank managers on the details of their seeming cover up in the mess, since their actions led to the loss of the public’s confidence in the banking system (Zingales, 2008).

References

Al-Badawi. (3 December 2008). Causes of the American financial turmoil and its effects on the global economy. Yemen Times.

Al-Qassas, M. (3 December 2008). Causes of the American financial turmoil and its effects on the global economy. Yemen Times.

Engdahl, F.W. (2008). Colossal financial collapse: the truth behind the Citigroup Bank “nationalization”. Retrieved December 4, 2008, from

http://www.globalresearch.ca/index.php?context=va&aid=11117

Makin, T. (2008). The global financial crisis: characteristics and causes. Retrieved December 4, 2008, from

http://www.brisinst.org.au/issue-details.php?article_id=345

Shaker, F. (3 December 2008). Causes of the American financial turmoil and its effects on the global economy. Yemen Times.

University of Chicago Graduate Business School. (2008). Curriculum vitae: Luigi Zingales. Retrieved December 4, 2008, from

http://faculty.chicagogsb.edu/luigi.zingales/vita/

Waggoner, J., Lynch, D.J. (19 March 2008). Red flags in Bear Sterns’ collapse. USA Today

Zingales, L. (2008). Testimony before the House of Representative’s Committee of Oversight and Government Reform.

http://oversight.house.gov/documents/20081006103245.pdf