Introduction
The financial crisis of 2007/9 was the worst in the U.S. since the Great Depression of the 1930s. It was the cause of the failure of some of the biggest financial institutions including Washington Mutual which was closed in 2008, and its assets transferred to JP Morgan. In 2008, the crisis reached its peak with loans dropping dramatically to the lowest levels to be witnessed in a half a century. For example, new loans to large borrowers fell by 47 percent in the fourth quarter of 2008 as compared to the previous quarter and by 79 percent relative to the second quarter of 2007 when credit boom was at its peak.
New loans to real investment dropped by 14 percent and a fall at the same rate were recorded in loans for restructuring when compared to the figures recorded during the peak of the credit boom (Ivashina and Scharfstein 319). This paper discusses the causes of the 2007/2009 economic crisis which was the primary cause for the failure of Washington Mutual (WaMu). When WaMu wound up, it became the biggest financial institution in the U.S. to close its doors because of the crisis. However, WaMu was a victim of the notion that there are institutions which are too big to fail; unfortunately, it was not one of them. In fact, WaMu’s assets were transferred to one of those institutions that are perceived to be too big to fail. The paper also evaluates the resolutions that have been proposed by different scholars on how WaMu would have prevented its failure and how stakeholders in the banking sector can prevent reoccurrence of such a financial turmoil.
Causes of WaMu Failure
WaMu’s causes of failure cannot be divorced from the causes of the 2007/2009 economic crisis that started in the U.S. in 2007. Acharya et al. (2009, 98) argue that the credit boom and housing bubble were the underlying reasons for the crisis. They hold that the rapid growth in debt-to-national income ratio from 3.75:1 in 2002 to 4.75:1 in 2007 was an indication that financial positions of many lenders were not right. The concern was made more pronounced when they compared the growth in this ratio with those of the past years and discovered that it had taken ten years to grow debt to that magnitude in the 1990s. Blundell-Wignall, Atkinson, and Lee (2008, 2) suggest that the financial turmoil that led to the failure of WaMu was caused by global macro policies on liquidity and ineffective regulatory framework.
The policies which affected liquidity at the time created a scenario of an overflowing dam (Moon 12). The interest rates had reduced to near-zero percent in the U.S. and other big economies like Japan and China which led to massive accumulation of reserves in Sovereign Wealth Funds, and they all helped to cause the overflow (Blundell-Wignall, Atkinson and Lee 2). The regulatory regime started in 2004 to direct money into mortgage securitization and off-balance sheet activities and by 2007, the pressure was too much that the sectors could not hold anymore, and the harm had already been done.
Chomsisenhphet and Pennington-Cross (2006, 31) hold that the genesis of the financial turmoil of 2007/2009 was the subprime mortgage market. Subprime lending was relatively new in the U.S. at the start of the financial crisis and institutions like WaMu did not know the level of risk they were exposed to by engaging in it. One of the unique aspects of this type of lending in comparison to the traditional loans was that it gave loans to borrowers who would not qualify under the old methods. Hence, it expanded lenders loan book and increased the number of homeowners (Chomsisenhphet and Pennington-Cross 31). However, it carried greater credit risk than the convention mortgages, and this was the cause of the bubble in the housing market. On the other hand, Clessens et al. (2010, 267) argue that the economic crisis cannot be blamed on just a single factor. They note that there was no major difference between the causes of the crisis and those of yesteryears. However, these factors have had a different impact on different countries. Some of the reasons for the crisis and were in previous economic turmoil included asset price bubbles and deficits in current accounts Clessens et al. 267). However, the 2007/9 economic crisis was unique because new factors such as augmented financial integration and reliance on wholesale financing played a significant role in the spread of the problem across the globe.
Crotty (2009, 563) traces the causes of the financial crisis as far as the late 1970s when the radical financial deregulation was initiated. The deregulation had taken form of cycles which were accompanied by fast financial innovations that triggered strong financial booms that eventually led to the crisis. In response to the crisis, the government initiated bailout measures which enabled the affected institution to commence their expansion. Consequently, the financial markets became larger and this is the reason for the great impact of any crisis to society Crott 563). Hence, the government must consider providing even bigger bailouts to those suffering. Fahlenbrach and Stulz (2009, 1) sought to find out whether there was a relationship between credit crisis and CEO incentives and share ownership before the commencement of the turmoil. They did not discover any correlation between the two as there was no any evidence that bank’s CEOs with good incentives performed better during the crisis than those who had lower incentives (Fahlenbrach and Stulz 1). The approach used by these authors to investigate the financial crisis is unique and valuable because it tended to break from the tradition by looking at the organizational factors which caused the crisis.
Freixas, Parigi, and Jean-Charles (2000, 612) believe that the causes of a financial crisis originate from the payment system used in the economy, the interbank market and the derivative markets. They suggest that the regulator has a major responsibility in preventing the financial crisis from occurring by providing a firewall to stop the crisis from spreading to other institutions. The contagion across institutions stems from the presence of financial contracts (613). The contracts are essential in providing liquidity and risk sharing in financial intermediaries, and the regulating authorities must design models to be used by the central bank to deal with the systemic shock.
Garcia (2010, 175) identified four stages which a bank goes through before it can be declared a failure. The first stage involves changing of philosophy, inattentive board, dominant person, high-risk lending and lack of expertise. Other than corporate governance issues, the first stage of a bank failure contains risk management issues such as lack of strategic plan and weak risk management systems, and lending concentration matters such as generous underwriting, poor internal controls, and aggressive growth. The second stage of a bank failure is characterized by violations of laws and regulations, insider abuse, disregard of examiners, poor diversification, financially strong image, fast growth in niche and high fee income.
The third stage of a bank failure is characterized by a lot of opposition to regulators, issues with accounts, MOU and board resolutions, decline in earning, insufficient loan loss reserves, impaired capital, significant loan concentration, growth plateaus and credit problems. The final stage of a failing bank is characterized by enforcement actions, the departure of key officials, severely deficient capital, and massive loan losses (Garcia 175). The enforcement action which comes at the fourth stage plays an insignificant role in correcting the situation because the greatest damage occurs in the second and the third stages.
Gorton (2009) believes that the credit crisis of the 2007/9 was contributed to a great extent by the banking panic. He describes the banking system as the ‘shadow banking system which was at the core of the credit crisis, and that was the reason for its vulnerability to a banking panic. A banking panic refers to a systemic occurrence that results from the banking system’s inability to honor its obligations, and it is bankrupt (Gorton and Metrick 425; Wicker 24). The 2007/9 banking panic was different from what had happened in the past because it was a wholesale panic. In the past depositors were running to the bank to claim their funds, and since the banks would not meet the requests, the banking system would become insolvent. However, in the recent banking system panic, financial institutions were going to other financial institutions by avoiding renewing sales and repos or increasing the repo margins and this triggered enormous deleveraging which eventually caused collapse in the banking system.
Harrington (2010, 319) blames insurance sector for the crisis and holds that American International Group (AIG) and the insurance sector in general had a role in the crisis which led to the failure of Washington Mutual. The insurance sector presents a systemic risk to itself and other non-bank financial institutions. Jean-Charles (2009) had a different opinion on the causes of financial crises and believed that political interference contributes significantly to the exacerbation of banking crises. He argues that it is detrimental for political authorities to pressurize banking regulators to bail out institutions which should be allowed to fail. Prem (2008, 868) believes that the auditors need to be blamed for the failure of some financial institutions like WaMu because of failing to raise the alarm early enough.
Resolution
Financial institutions with major impact to the economy if they fail should be regulated in an ex-ante manner so as to reduce the risk of their failure and possibility of asking the taxpayers to bail them out. The regulation structure of these institutions should be designed in a way that they help to identify systematically important financial institutions (Acharya, Engle and Richardson 59). When the failure of WaMu was imminent, it was sold off to JP Morgan. The acquisition of WaMu by a larger bank confirmed to longstanding belief that some banks were too big to fail. It seems that WaMu was not big enough, and it was not bailed out like the largest banks that were facing the same nightmare (Zhou 44). As such, the system should be based on regulations that ensure the sustainability of the sector even in the midst of problems.
After the bailout by the taxpayers’ money, the big banks have managed to reorganize their operations and become larger and more complex than they were before the crisis. Hence, there is a need to pay more attention to this development as there is a notion among some banks that they are too big to fail (Barth and Prabha 1). Gorton and Metrick (2010, 2012) believe that introduction of new regulations can help to improve the functioning of shadow banking system and make it less susceptible to panic. Additionally, insurance regulation should not have been ignored in resolving the crisis. Insurance plays an important role in enhancing business to mitigate risk and particularly in the financial sector this could have played an important role since the risks could have been insured.
Inatowski and Korte (2014, 1) recommends for the development of a framework to test the implications of changes in bank resolution regimes in averting future financial crises. They discovered that reasonable improvements in resolution regimes would enhance the overall bank discipline. According to Nimo (2015, 745), a financial crisis like the one happened between 2007 and 2009 can be avoided by requiring financial lawyers to be issued with negative certification. The scholar argues that the position of lawyers in financial institutions can help to offer the best advice to executives on the best way to manage legal risks and approve the services of external counsels. Lawyers are usually at the center of the decisions involving efficient use of capital. Therefore, lawyers should be required to observe a high level of ethics to ensure that financial institutions are stable at all times.
Porter (2008) proposes to financial institutions like WaMu and other types of organizations in different sectors of the economy to use the five competitive forces to shape their strategy and prevail in difficult economic times. The five forces which shape competition in any industry are threats of new entrants, the power of suppliers, the power of buyers, the threat of substitution and rivalry among the current market players. The strategy can enable such institutions to formulate strategies for such institutions in different phases of their growth and development. Further, it enables an organization to identify its position in the market, which is essential in the formulation and implementation of a competitive strategy that will enable such businesses to achieve comparative advantage in the market.
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