What Events Led to the Financial Crisis - Essay Example

? FINANCIAL CRISIS After reviewing the case and our discussion in what events led to the 2008 financial crises? The origin of the financial crisis was the set of government policies that encouraged ownerships for new homes, easy access to sub-prime lending, faulty trading practices on behalf of buyer as well as sellers, prioritization of short term lending over long term lending, and most importantly the lack of adequate capital base in banks that made their solvency vulnerable. The reduced availability of credit reduced the investor confidence that affected the global stock markets in a complex manner. The immediate cause for the trigger of financial crisis was the bursting of U.S. housing bubble that peaked from the year 2005-06. There were already reports of rising default on subprime mortgages that further fuelled quickly thereafter. Such mortgages are usually given to borrowers with below average credit ratings which are mainly due to their higher average risk of evasion in loan repayment. The financial institutions often charge higher interest on subprime mortgages in order to compensate for the risk taken. Thus, as the banks began clear out more loans to home owners, the housing prices rose. The easy accessibility of credit in U.S. in addition to large foreign inflows led to the boom in construction and increased consumer spending that was mostly financed by debt. The falling prices of houses resulted in more homes less worthy than mortgaged loans which provided a financial incentive to financial institution to take possession of mortgaged property when the mortgagor failed redeem loans leading to financial crisis in banking sector (Brunnermeier, pp.78-81). 2- What would a commercial bank's balance sheet have looked like in 1973? What would an investment bank's balance sheet have looked like in 1973? Considering Bear Stearns in 2007, was it closer to a commercial bank or an investment bank? During the period of 1973, the commercial bank operations involved both issuing loans as well as taking deposits. The loans and deposits were shown in the lenders’ balance sheet. On the other hand the investment banking operations involved underwriting activities such as underwriting equity and debt. In addition to underwriting activities, the investment banking operations also included buying and selling of securities. The investment bankers would buy securities such as debt and equities from a syndicate bank and then sell such security to investors. Thus, the investment bank would act like a market maker and their functions were similar to that of a broker or a dealer. Historically, the financial companies could slot in both investment and the commercial banking activities. It was only after the Great Depression Era that the congress realized the intrinsic risk of underwriting securities and hence decided to separate the commercial banking activities from the investment banking activities. Such a step was taken to protect the depositors from the risk of defaulting from underwriting activities. The Congress issued Glass-Steagall Act to separately identify the commercial and investment banking activities of the banks. The distinction between the investment banks and commercial banks narrowed during the mid 80s. In the late 80s, Fed started removing the Glass-Steagall Act that restricted the interference of investment activities from commercial activities. This Act was ratified by the Congress in the year 1999 with passing of Gramm-Leach-Bliley Act. After the issue of this new act many investment and commercial banks were consolidated that resulted into renowned conglomerates like UBS group, Citi group, JP Morgan Chase, and so on. But other exclusive investment banks like Bear Sterns decided not to enter the commercial banking activities and take deposits. 3- Bear Stearns fell quickly. On March 10th, SEC Chairman Christopher Cox described Bear as being "well-capitalized". Do you agree with this assessment? Why or why not? Bear Sterns & Co. also known as Bear was the fifth-largest investment bank in USA at the beginning of the year 2008. But during the second week of March 2008, it had to burnout all its $18 billion cash reserves. The bank survived till March 14 only because the US Federal Reserve Bank announced that it would finance the bank for a period up to 28 days. But despite of the Fed’s financial assistance and liquidity injection into the investment bank, Bear’s condition worsened and on evening of Friday March 14, 2008 the CEO of Bear came to know that Bear’s access to Fed’s lending support would only last for 24 hours more. Such a step was taken by Fed in order to limit the impact of spreading Bear’s problems to other banks in the system. On March 16, 2008, JP Morgan Chase offered to buy Bears Sterns & Co for $2 per share to which the bank accepted. The credit environment in US worsened and the NY Fed announced the reviving plan to infuse liquidity into investment banking by lending $200 billion in Treasury bills for 28 days. But the Fed’s decision was not seen as favorable to many economists’ since opening a discount window for an already damaged sector could lead to financial collapse in the economy. From the above discussion it can be said that SEC chairman Christopher Cox gave his positive views regarding Bears only as an attempt to ease investor panic in the economy while Fed knew that the collapse of Bears was inevitable. 4- JP Morgan's CFO (Cavanagh) indicated that they enjoyed two advantages over Bear (or firms like Bear). The first advantage was access to the discount window which provided them with unlimited access to use assets as collateral to gain liquidity (page 3 and Appendix). What is the second advantage? In your answer, discuss what is meant by the term "fortress balance sheet". JP Morgan Chase was formed from the merger of multiple banks and financial institutions. JPMC operated in both commercial banking segment as well as the investment banking. The total asset of the bank at the end of 2007 was over $1.6 trillion with market capitalization of $147 billion. It employed over 180,000 employees and operated in over 60 countries which makes it globally diversified. Consequently, JPMC was much larger compared to Bear and also more diversified in operations. This was because while Bears operated exclusively in the investment banking, JPMC operated in commercial banking as well. This helped the bank to get access to discount window offered by the NY Fed during the 2008 financial crisis. Such discount window was closed for investment bankers such as Bear after March 16. Hence, from the above discussion it can be said that JP Morgan enjoyed two advantages over Bear. Fortress balance sheet assures liquidity and capital adequacy by defining level that which may be higher than regulatory requirements but is at the same time maintained by major competitors for sudden contingencies and emergency requirements. The CFO of JP Morgan Cavanagh defined that the liquidity approach must consist of four basic components namely, Stress testing (to understand the probability and extent of losses); large and adequate capital base in the form of cash; liquidity reserves to identify the assets that are turning illiquid; and term financing to remove inconsistencies of asset-liability mismatch. Another key feature of the Fortress balance sheet was that it followed conservative accounting policies. 5- What aspects of how JP Morgan Chase was managed struck you as important? In your answer, you may wish to create a table in Word and divided your responses into three categories: Control/Process, Culture, and Incentives. Culture - While Bear’s management policies encouraged their workforce to hold major portion of stocks until they leave the firm, JPMC’s management team focused more on cutting cost, improving business process with faster responses to changing environment and also investing significantly into technology and infrastructure of the bank. The work culture at JP Morgan is based on self-reinforcement that leads to question every individual at JPMC about where they are and where they ought to be by identifying what are the hurdles to reach there and how to take care of those problems. Operations - The CEO of JP Morgan, Dimon required that even though JPMC was the result of many mergers but still the entire firm will have to use the same format financial reports to increase the reliability, transparency, and consistency in their process. Such uniform reporting policies would ensure the true reflection about the state of affairs of the business in terms of direct cost, profit margins and expenses which are shared as well as owed. No such business strategy to improve the process of Bear was taken by the investment banker. Incentive Schemes - The annual bonus of JP Morgan was determined after evaluating the qualitative and quantitative factors. The quantitative factors included operating earnings that measures the investment for activities related to growth of business and technology; credit and risk management that ensures client satisfaction; return on capital employed that ensures liquidity and capital management. The qualitative factors on the other hand includes quality of earnings, building culture, execution success for implementing strategic plans, supporting firm’s values and so on. The incentive scheme criteria of JP Morgan Chase can be summarized as follows: (Source: JP Morgan Chase & Co., 2007) The criteria for incentives for the business heads were based on performance on their line of business and also helping to achieve the objective of business as a whole. Most of the annual bonuses were in the form of stock options that has to be locked in for a period of three years. 6- Why did the government turn to JP Morgan to bailout Bear? What "fair market price" would you put on Bear, using the case? The credit environment in US worsened during 2007 and the NY Fed announced the reviving plan to infuse liquidity into investment banking by lending $200 billion in Treasury bills for 28 days. But the Fed’s decision was not seen as favorable to many economists’ since opening a discount window for an already damaged sector could lead to financial collapse in the economy. The reason why the government turned to JP Morgan to bailout Bear was because Bear was operating exclusively as investment banker where as JPMC was operating in both investment banking and commercial banking segment. In order to stop spreading the financial contagion of Bear into the economy the government decided to provide financial assistance. Since Bear will not have access to discount window directly (direct bailouts of investment banks by government could spread risk of collaterals and underlying of investment into economy), leaving limited choice for the government to save the bank from filing bankruptcy. In the case study it is given that for the year ending 2007, Bear reported total equity of $11.8 billion (book value), assets worth $138 billion (owned) and about $257 billion of assets in the form of collaterals. Based on the above data, the fair market value of Bear should be $11.6 billion which excludes guarantees and commitments made by the bank. But this was overvalued since the risk associated with mortgage backed securities was ignored where as the true fair market valuation of Bear should have been at $8-$12 per share that would require cash outflow of about $945 million to $1.5 billion in an all cash buyout deal. 7- Was there a compelling commercial rationale for JP to buy Bear? Bears operated in three main segments of investment banking namely wealth management, capital market, and global clearing services. But the main attraction of Bear was the fixed income which the business gets. The fixed income contributed over $3 billion compared to less than $2 billion from investment banking and much less in asset management and mortgage backed securities. Bear was one of the largest mortgage security market players with over 30% of owned securities. The prime brokerage business of the bank was estimated to be over $2.9 billion. During the period of 2004-07, Bear was the largest security underwriter for US MBS (Mortgage Backed Securities). Bear also owned EMC Mortgage which was considered as one of the most aggressive player in mortgage market. Bear reported total equity of $11.8 billion (book value), assets worth $138 billion (owned) and about $257 billion of assets in the form of collaterals that estimates its total market capitalization over $11 billion. All of Bear’s operations and activities were financed by a combination of equity, long term debt, and collateral securities. Bears also had considerable commodities and energy operations. The only drawback of Bear was that it did not have direct access to Fed’s discount window which made it dependent upon the market for funding and liquidity requirements. From the above discussion it can be said that Bear was a compelling and commercially attractive buyout opportunity for JP Morgan and that too with $2 per share valuation. 8- Was there a compelling "social" or moral reason for JP Morgan to buy Bear? The social and moral reason that made JP Morgan to buyout Bear was to limit the possibility and impact of financial crisis in the broader markets. Even though no one at that time was clear about the extent of impact that can arise from the failure of Bear but it was felt that such failure would lead to widespread insolvency, damaged financial system, and ultimately threaten the stability of the economy. Hence, failure of Bear posed significant threat to damage economic activities. During the period of 2004-07, Bear was the largest security underwriter for US MBS (Mortgage Backed Securities). Bear also owned EMC Mortgage which was considered as one of the most aggressive player in mortgage market. Bear reported total equity of $11.8 billion (book value), assets worth $138 billion (owned) and about $257 billion of assets in the form of collaterals that estimates its total market capitalization over $11 billion. In such a scenario if JP Morgan and the government backed out from rescuing Bear, the broader impact would lead to consequences of higher borrowing cost, lower income for individuals and families, higher cost of education, rising unemployment, falling stock markets, slower economic activity, slumping growth rate, lower value in pension schemes and higher consumer prices. From the above discussion it can be said that the social impact of not rescuing bear would be significant and hence JP Morgan’s decision to buy Bear was justified. 9-Looking back at this event from 2013, do you agree with Dimon's decision? Why or why not? Initially Dimon disagreed to buyout Bear due to inherent risk associated with Bear’s $40 billion mortgage backed securities. In addition, JP Morgan’s time allotment to assess and value Bear at fair market price was reduced from one month to 48 hours. Dimon’ decision changed only after the US Fed offered financial assistance up to $30 billion in case JPMC suffers losses due to defaults and illiquidity of Bear’s securities. In addition to that, the initial offer made by JPMC’s CFO to buyout 90% of Bear’s stocks for $3 billion at $28 per share was overvalued. JPMC was considering valuing Bear at $8-$12 per share that would require JPMC to shell out about $945 million to $1.5 billion. Hence, Dimon’s earlier decision of rejecting buyout plea of Bear was justified on the ground the bank’s fair market value was overvalued and the risk associated with mortgage backed securities was underestimated. But on the other hand the commercial attractiveness of Bear could not be overseen by Dimon. Bear was one of the largest mortgage security market players with over 30% of owned securities. The prime brokerage business of the bank was estimated to be over $2.9 billion. All of Bear’s operations and activities were financed by a combination of equity, long term debt, and collateral securities. Bears also had considerable commodities and energy operations. The only drawback of Bear was that it did not have direct access to Fed’s discount window which made it dependent upon the market for funding and liquidity requirements. Hence, from the above discussion it can be said that Dimon’s decision was justified. Works Cited Brunnermeier, M. Deciphering the Liquidity and Credit Crunch 2007–2008. 2009. Web. April 17, 2013. . Read More