Introduction
In late 2007, the Dow Jones Industrial Average (DJIA) closed at a record low. Stock markets around the world nose-dived alongside the DJIA. Turbulence in the sub-prime segment of the US housing market, paralysis of the credit markets, excessive lay-offs in organizations, steep decline in investments etc. were all some of the indicators that the world was heading for a massive credit crunch. In the words of Mr. Strauss-Kahn, head of IMF, “Intensifying solvency concerns about a number of the largest U.S.-based and European financial institutions have pushed the global financial system to the brink of systemic meltdown” (BBC News, 2008, para. 10).
Several factors were held responsible for the global recession that initiated in America and subsequently shook the global economy. There was a substantial upsurge in housing and equity prices later referred to as the ‘housing bubble’. Investors failed to realize that the housing prices could ever go down. This optimistic attitude led to an increase in demand for housing, while supply remained fixed. Despite relative stability in household incomes, more and more people were able to afford houses due to easy access to credit. The Federal Reserve reduced interest rates -particularly federal funds rate- to such low levels that it fueled the borrowing binge which led to skyrocketing real estate prices. This rising level of private debt in the economy was complicated by the unprecedented level of mortgage securitization in terms of collateral debt obligations.
During the mid-1990s, U.S. households borrowed an annual average of approximately $200 billion in the form of mortgages for home purchases. The figure rose abruptly to $500 billion for the period 1998–2002 and to $1 trillion from 2003 to 2006.
Rationale
As explained above, several interlinked factors created an environment that led to the Great Recession. Therefore, it would not be fair to blame a single factor for the entire crises. The focus of this paper is on investment banks that played an important role in bringing about the Great Recession. In my opinion, the housing bubble was a result of a lax attitude of financial markets. However, it is important to understand how the financial regulatory environment and optimistic consumer behavior led investment banks down the road to destruction. Therefore, I chose to analyze three major investment banks i.e. Goldman Sachs, Bear Stearns and Morgan Stanley, to understand the Great Recession.
Were Investment Banks Guilty?
Prior to the crises, investment banks were securitizing the mortgages and trading them all across the globe. In 2007, the sub-prime mortgage market started to collapse as borrowers started defaulting. As a result, investment banks started losing money. While the sub-prime mortgage crises less than $2 trillion mortgage-based securities, the explosion of the housing bubble created a ripple effect, leading to further losses on mortgage-based securities. As officials at investment banks were relying on these mortgages for huge annual bonuses, they pressurized their employees for global trade of securities that packaged mortgages and other forms of debt. In retrospect, it can be seen that these bank officials were undertaking enormous risks just for short-term gains. As the crises unfolded, these short-term gains evolved into massive long-term losses.
The significant role of investment banks begins with mortgage lenders loaning money to prospective home buyers and then seeking to write-off those loans. This led to the creation of complex mortgage-backed securities. Initially, the system worked smoothly, but then it started unraveling. Given the huge amount of securitization fees earned by banks and Wall Street firms, these sub-prime mortgages stopped being a means to stimulate flow of capital for the housing market; rather they became ends in themselves. As a result, Wall Street traders looked for more and more mortgages in order to create new financial instruments that produced a regular flow of fees for their firms and large bonuses for themselves. As demand outstripped supply, lenders started making riskier mortgage loans. Credit standards plummeted and predatory lending reached for the skies. However, no real problems were to be expected as long as home prices kept rising. However, the situation could not stay that way forever.
As soon as the housing prices stopped increasing, the bubble burst and the sub-prime mortgage market froze. Investment banks, hedge funds and several other investors found themselves holding suddenly unmarketable mortgage-backed securities. It was then that America began to feel the aftermath of the economic assault. The following sections will analyze the role of three major investment banks in the recession.
Bear Stearns
The fifth largest investment bank in the United States, Bear Stearns had been in operation for nearly 85 years when its involvement in subprime mortgages raised some eyebrows. The bank was known for its aggressive willingness to take risks. Although it was one of the most highly leveraged Wall Street firms, the bank’s management had a history of focusing on short-term opportunistic returns rather than long-term strategic planning. Bear Stearns had an interesting profitability model for mortgage securitization. It vertically integrated the mortgage business, by directly dealing with mortgage originators, bundling these mortgages and securitizing them. As a result, they earned profits with every transaction along the way.
Despite overwhelming risks of subprime mortgage securitization, the bank increased its exposure to the market in 2006 and 2007. It created a range of hedge funds that bought different classes of mortgage-backed securities during the housing bubble. As the funds became heavily invested in securities with subprime mortgages, they experienced massive losses when the housing bubble burst. As a result, the funds failed and Bear Stearns had to buy them for $1 billion. Consequently, the investment bank was left with numerous assets it could not sell.
However, Bear Stearns worst nightmare was not over yet. As soon as its mortgage businesses and investments weakened, Bear Stearns was downgraded by the credit rating agencies. The bank’s creditors began to doubt its ability to repay debt and denied the credit needed for day-to-day business operations . In desperate need to reduce its portfolio of mortgages and raise cash, Bear Stearns made at least six failed efforts to raise billions of dollars. The giant bank became unable to raise any more cash by mid-March 2008.
Rapid loss of liquidity led the bank to near insolvency. It approached JP Morgan Chase for a $30 billion credit line. However, JP Morgan Chase wanted direct government intervention, so the government agreed to loan $12.9 billion to Bear Stearns on behalf of JP Morgan. The intervention was followed by further downgrading of its credit ratings. Subsequently, JP Morgan was requested by the Federal Reserve to buy Bear Stearns, while the Fed shouldered the majority of the burden of purchase .
In short, Bear Stearns collapsed because of their over-exposure to mortgage-based securities and their high leverage ratios. The resultant liquidity crisis led to a run on the bank, causing insolvency.
Goldman Sachs
One of the oldest investment banks, Goldman Sachs was founded in 1869. Despite its mission of being committed to the interests of its clients, Goldman repeatedly pursued personal gains at the sake of customer interests. Not only did Goldman market risky mortgage-related securities, it placed large bets on failure of the mortgage market. In other words, Goldman committed a heinous crime by deliberately setting up its clients for losses and earning massive profits by betting on those losses. It took advantage of the reasonable expectations of its customers that the bank would not sell products intended to fail. Against its clients’ interests, Goldman sold securities backed by loans from poor-quality lenders. Its excessive marketing of the synthetic financial instruments put the entire economy at risk. Despite overwhelming evidence, Goldman refuses to accept its involvement in any such bets.
Evidence shows that by early 2007, Goldman moved away from its long-positions on the mortgage market to short-positions in order to gain from the crash of the market. Throughout 2007, it took large net short positions which could not be rationalized as necessary hedges against risks the bank took to make a market for its customers. These short positions reflected massive betting against the mortgage-securities market. The clients suffered major losses, but Goldman won big time. However, as the crises intensified in late 2008, the bank’s viability was questioned. Therefore, Goldman Sachs converted to a traditional bank holding company with approval from the Federal Reserve. Considering the bank too-big-to-fail, the government paid $10 billion as part of a bail-out plan for Goldman Sachs by late 2008.
Morgan Stanley
Morgan Stanley, a 74 year old multinational financial corporation, played an important part in the Great Recession. Its excessive risk taking attitude and massive borrowing was demonstrated in its leverage ratio of 3 to 1. Moreover, it was heavily involved in packaging and selling sub-prime mortgages. As explained before, high bank leverage made investment banks highly vulnerable and extremely risky.
Initially, the bank was not heavily invested in the subprime mortgage business. However, when John Mack became CEO in 2005, the bank committed to an aggressive investment strategy. The bank started taking on bolder gambles at the expense of client interests. In order to access subprime mortgages and package them into complex, synthetic financial instruments, Morgan Stanley bought Saxon Capital which was the “King of Subprime” at the time. Bad underwriting standards and predatory loans became major problems in the subprime mortgage business, yet Morgan Stanley did not deviate from its course.
The entire mantra behind the subprime mortgage business was that the riskier the loans, the higher the bank profits. Subprime lenders, like New Century Financial Corporation, thrived on the credit backing provided by investment banks like Morgan Stanley. They would use the funds from investment banks to source subprime loans which Morgan Stanley would repackage and sell to institutional investors. Even when no other bank was willing to fund New Century, Morgan Stanley supported the almost-bankrupt lender.
Even the organizational culture of Morgan Stanley stimulated aggressive risk taking for the sake of financial rewards. The bank bragged about ripping off clients’ faces. It experienced the single largest proprietary trading loss in Wall Street history, when one of its hedge funds, Global Proprietary Credit, lost billions in the residential mortgage-backed securities market. The fund was headed by Howie Hubler, who subsequently resigned and took a huge amount in back pay with him.
Consequently, the long history of Morgan Stanley as an investment banker for major corporations came to end. The bank was almost bankrupt by September 2008. There was a write-off of $15.7 billion in bad investments. Liquidity concerns escalated as cash reserves diminished. When the collapse of Morgan Stanley became inevitable, the government proposed selling it to JP Morgan Chase for $1. However, Morgan Stanley refused as it had the Japanese bank, Mitsubishi, interested to buy a stake in Morgan Stanley.
Conclusion
According to some economists, the underlying cause behind the Great Recession could be the highly self-serving Wall Street culture. The toxic mortgages injected into the financial system by these Wall Street companies led to unsurmountable losses for the global economy. Some say that the entire fiasco was driven by the rise in demand for home financing, thus blaming the low-income prospective home buyers. However, it might not be the only kind of demand in question. The demand created by Bear Stearns, Goldman Sachs and Morgan Stanley for raw materials needed to create such high-yielding financial instruments equally contributed to the chaos. While some criticize lenders for their devious practices, others blame borrowers for accepting loans they could never repay. However, the driving force behind the sub-prime mortgage lending explosion was neither lenders nor borrowers. In fact, the blame lies on the creators of the mortgage-backed securities. Better yet, the Great Recession can be blamed on the never ending, unrelenting, unsatisfying greed of the human race.
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