Postings and assignments for students in Econ 3334 at UH
Tuesday, March 25, 2008
How did this happen?
The Economist has a nice article describing the conditions that led to the current financial situation in the U.S.. It's more complex than what we discussed in class, but it is a nice summary.
4 comments:
Anonymous
said...
The first few paragraphs talk about how Bear Sterns failure was caused by the modern inter-connected financial system of the 21st century. The author is absolutely right. Finance has changed dramatically since the 1960's, primarily because of three "key" events. The first event was the use of Euro-dollars by European banks. When Soviets started to export oil during the 1960's they brought American dollars into their economy. They did not have much use for the dollars so they invested them in European banks. The Europeans then realized that they could loan out the Dollars to other countries and thereby bypass the limitations of the Bretton Woods system which prevented short term financial flows between countries with European currencies. This led to the second "key" event; the collapse of the Bretton Woods system. After the collapse, European countries were able to value their own currencies which could now be determined by the market. The third "key" event that dramatically changed finance was the series of oil shocks, which redistributed capital around the world with Petrodollars. Soon after there was an increase in investment in emerging markets by private lenders to non-OECD markets such as Brazil, China, India, and Russia which led to instability. That is where George Soros comes in, in which case he made millions of dollars by buying and selling the currencies of these unstable countries in the 1990's. Financial derivatives were created to protect investors from risk, and the financial world became highly interdependent from there on afterwards. Because of this interdependence, when one area of finance fails, such as the sub-prime home loan crisis, it can have a rippling effect across many industries and markets, which in this case caused the failure of Bear Sterns.
The next four paragraphs explain the increase in finance from 1980 to 2007, explaining that the profits for the financial sector were not made from initial rising asset prices and falling interest rates. Technology and corporate restructuring only boosted profits, which increases the yields on investment portfolios to about 14%. Then, when the dotcom bubble burst, consumer spending and exports and investments were weak, but the financial sector remained strong by using debt, securitization, and proprietary trading to decrease risk, increase profits, and increase fee income. These are some of the financial derivatives that were created to protect investors from unstable markets and currencies, as mentioned previously. One of the major derivatives are "Credit-Default Swaps" which are kind of like insurance to protect against some one who defaults on their loan, except without any assets. As the article states, the value of credit-default swaps is nearly $45 trillion. Banks thrive on trading debts between each other, which has been difficult to control. Previously in time there were limits that were set by the gold standard and credit controls, but now there are many different factors to take into consideration. The recent crisis of the sub-prime lenders testifies to the lack of controls.
The failure of Bear Sterns has proven to be a major event because it has attracted the attention of the Fed. Bernanke is planning to lend money to Bear Sterns and try to steer the company away from bankruptcy. If the Fed is taking unprecedented actions, then maybe it is a reinforcing sign that the modern finance services sector need more "supervision" by government institutions. Money flows have become so inter-connected in the world of finance that the entire economy may be affected by the collapse of just one part of it. It almost seems as though the Fed’s involvement with Bear Sterns is to serve as common law, so that the Fed will know what to do in future similar events.
This article talks about the recent peril of the financial system and ways it can be fixed. They cite an interesting study that says that financial profits of companies have grown faster than regular profits. Moreover, the article correctly points to the source of the growth in the financial industry, rising asset prices. Even though inflation was relatively tame during the 1990’s, we can argue that we had tremendous “asset price inflation” from which we can point out the recent asset bubbles. Some of the large leverage by investment banks such as Goldman Sachs ($40 billion of equity to $1.1 trillion of assets) and Merrill Lynch ($30 billion of equity to $1 trillion of assets). The article says that this leverage is OK during economic booms, but what happens to the value of those assets when economic growth slows or even stops? This could cause severe losses not only to their respective shareholders, but also to the taxpayer as well (for example, recent case of bailout of Bear Sterns by the Fed) Moreover, the rise in debt has been faster than the rise in asset values, creating a cycle type situation (more debt, you can buy more assets, and so on) The article argues that in some part, by focusing so much on short-term returns and compensating executives based on short-term performance, they would not care about the firm’s long term perspective. Some possible solutions to this problem, one of them increasing capital adequacy ratios (that is requiring banks to set aside more equity in order to “cushion down” an unexpected fall in asset prices) Spain has done this with some relatively success. The article mentions some of the bad judgment made by credit-rating agencies in rating bonds and assigning AAA ratings to debt bonds that should have not. Lastly, the article finishes predicting a relative decline in the financial industry being that it grew so much during the last 20 years and taking into the account the recent perils. Moreover, as learned about moral hazard in class, why should investment banks’ losses be paid by all taxpayers whenever they’re in trouble (i.e. Bear Sterns bailout, and I think there’s more to come) and while in the good years. I think this is socialism for the rich, you get to keep the gains but you can “spread” the losses along people who did not benefit, I find that very frightening in the fact that to me it is highly immoral. To conclude, this was an excellent article which I enjoyed reading and think this issue deserves more scrutiny since it affects us all.
The beginning of this article discusses the many events, which eventually led to the failure of the fifth-largest investment bank of Wall Street, Bear Stearns. This was definitely a shock to many people especially since it was not to long ago the Alan Greenspan stated, “Increasingly complex financial instruments have contributed to the development of a far more flexible, efficient, and hence resilient financial system than the one that existed just a quarter-century ago.” Bear Stearns failure can be directly related to the fact that many financial groups have managed to go by unchecked and are now quite prone to conflict of interest and to fraud. This fraud is highly visible in the sale of sub prime mortgages. The people in charge continued to take unnecessary risk and partake in fraudulent activities because they knew that, “if disaster struck, someone else…would end up bearing at least some of the losses.”
The article then goes on to state that the failures and problems that are being experienced today are directly traced back to the 1980s. The 1980s started a pattern of growth in profits for the American financial-services industry, which may just now come close to an end. The article explains to us that during this time, the profits did not come from the increasing asset prices or the falling interest rates. They were able to make profits and remain strong for so long by using the debt from the dotcom bubble burst as a way to increase profit and income. Banks made a lot of money by trading these debts with each other, only to find out that they really were not worth much at all.
The reason why the failure of investment banks like Bear Stearns are so important to understand and research are to find how to make sure other banks do not experience the same outcomes. Ben Bernanke and the Federal Reserve made plans to supply Bear Stearns with adequate money to stabilize and keep from filing bankruptcy. Now, Bear Stearns has been bought out for pennies on the dollar. This should stand as a sign to other Banks about how they should and should not conduct business. This should also be a sign that the financial services industry needs to be watched more closely. If more supervision is not provided, more financial institutions could experience the same failures, resulting in harm to the American economy and the pocketbooks of the American people.
This article is about Bear Sterns failures, Wall Streets fifth largest investment bank and its correlation to the financial system. Reasons for the failure are connected to fact that their institutions was getting by without check ups or regulations. This increased the possibility of fraud and many other deceitful tactics. This was all because many managers were focused on short-term gains with disregard for long-term consequences. Their principle was in the event of disaster, someone else would bear the losses. The article goes on to talk about how finance has changed over the past decade because of the use of euro-dollars, collapse of the Bretton Woods system, and a series of oil shocks. This all lead to an increase in investment in markets and caused instability around the word. This instability not only affected markets, it affected industries (such as Bear Sterns). When economic growth slows, shareholders and taxpayers lose tons of money. Now there are some solutions to this process. One could be to increase CAR (capital, adequacy, ratios). So banks could hold more equity to soften the blow of falling asset prices. The Bear Sterns case is important to understand so that these outcomes can be avoided. There were plans to supply the company with enough to stabilize and keep them from filing bankruptcy. In class we talked about how investment banks losses are paid by tax payers. This should teach individuals and corporations that looking ahead, in some cases, is most important. Companies should not sacrifice ethics for a quick buck. Anything that may cause the company big losses in the future should be avoided. I’m sure Bear Sterns can attest to that.
4 comments:
The first few paragraphs talk about how Bear Sterns failure was caused by the modern inter-connected financial system of the 21st century. The author is absolutely right. Finance has changed dramatically since the 1960's, primarily because of three "key" events. The first event was the use of Euro-dollars by European banks. When Soviets started to export oil during the 1960's they brought American dollars into their economy. They did not have much use for the dollars so they invested them in European banks. The Europeans then realized that they could loan out the Dollars to other countries and thereby bypass the limitations of the Bretton Woods system which prevented short term financial flows between countries with European currencies. This led to the second "key" event; the collapse of the Bretton Woods system. After the collapse, European countries were able to value their own currencies which could now be determined by the market. The third "key" event that dramatically changed finance was the series of oil shocks, which redistributed capital around the world with Petrodollars. Soon after there was an increase in investment in emerging markets by private lenders to non-OECD markets such as Brazil, China, India, and Russia which led to instability. That is where George Soros comes in, in which case he made millions of dollars by buying and selling the currencies of these unstable countries in the 1990's. Financial derivatives were created to protect investors from risk, and the financial world became highly interdependent from there on afterwards. Because of this interdependence, when one area of finance fails, such as the sub-prime home loan crisis, it can have a rippling effect across many industries and markets, which in this case caused the failure of Bear Sterns.
The next four paragraphs explain the increase in finance from 1980 to 2007, explaining that the profits for the financial sector were not made from initial rising asset prices and falling interest rates. Technology and corporate restructuring only boosted profits, which increases the yields on investment portfolios to about 14%. Then, when the dotcom bubble burst, consumer spending and exports and investments were weak, but the financial sector remained strong by using debt, securitization, and proprietary trading to decrease risk, increase profits, and increase fee income. These are some of the financial derivatives that were created to protect investors from unstable markets and currencies, as mentioned previously. One of the major derivatives are "Credit-Default Swaps" which are kind of like insurance to protect against some one who defaults on their loan, except without any assets. As the article states, the value of credit-default swaps is nearly $45 trillion. Banks thrive on trading debts between each other, which has been difficult to control. Previously in time there were limits that were set by the gold standard and credit controls, but now there are many different factors to take into consideration. The recent crisis of the sub-prime lenders testifies to the lack of controls.
The failure of Bear Sterns has proven to be a major event because it has attracted the attention of the Fed. Bernanke is planning to lend money to Bear Sterns and try to steer the company away from bankruptcy. If the Fed is taking unprecedented actions, then maybe it is a reinforcing sign that the modern finance services sector need more "supervision" by government institutions. Money flows have become so inter-connected in the world of finance that the entire economy may be affected by the collapse of just one part of it. It almost seems as though the Fed’s involvement with Bear Sterns is to serve as common law, so that the Fed will know what to do in future similar events.
This article talks about the recent peril of the financial system and ways it can be fixed. They cite an interesting study that says that financial profits of companies have grown faster than regular profits. Moreover, the article correctly points to the source of the growth in the financial industry, rising asset prices. Even though inflation was relatively tame during the 1990’s, we can argue that we had tremendous “asset price inflation” from which we can point out the recent asset bubbles.
Some of the large leverage by investment banks such as Goldman Sachs ($40 billion of equity to $1.1 trillion of assets) and Merrill Lynch ($30 billion of equity to $1 trillion of assets). The article says that this leverage is OK during economic booms, but what happens to the value of those assets when economic growth slows or even stops? This could cause severe losses not only to their respective shareholders, but also to the taxpayer as well (for example, recent case of bailout of Bear Sterns by the Fed)
Moreover, the rise in debt has been faster than the rise in asset values, creating a cycle type situation (more debt, you can buy more assets, and so on)
The article argues that in some part, by focusing so much on short-term returns and compensating executives based on short-term performance, they would not care about the firm’s long term perspective.
Some possible solutions to this problem, one of them increasing capital adequacy ratios (that is requiring banks to set aside more equity in order to “cushion down” an unexpected fall in asset prices) Spain has done this with some relatively success. The article mentions some of the bad judgment made by credit-rating agencies in rating bonds and assigning AAA ratings to debt bonds that should have not. Lastly, the article finishes predicting a relative decline in the financial industry being that it grew so much during the last 20 years and taking into the account the recent perils.
Moreover, as learned about moral hazard in class, why should investment banks’ losses be paid by all taxpayers whenever they’re in trouble (i.e. Bear Sterns bailout, and I think there’s more to come) and while in the good years. I think this is socialism for the rich, you get to keep the gains but you can “spread” the losses along people who did not benefit, I find that very frightening in the fact that to me it is highly immoral. To conclude, this was an excellent article which I enjoyed reading and think this issue deserves more scrutiny since it affects us all.
The beginning of this article discusses the many events, which eventually led to the failure of the fifth-largest investment bank of Wall Street, Bear Stearns. This was definitely a shock to many people especially since it was not to long ago the Alan Greenspan stated, “Increasingly complex financial instruments have contributed to the development of a far more flexible, efficient, and hence resilient financial system than the one that existed just a quarter-century ago.” Bear Stearns failure can be directly related to the fact that many financial groups have managed to go by unchecked and are now quite prone to conflict of interest and to fraud. This fraud is highly visible in the sale of sub prime mortgages. The people in charge continued to take unnecessary risk and partake in fraudulent activities because they knew that, “if disaster struck, someone else…would end up bearing at least some of the losses.”
The article then goes on to state that the failures and problems that are being experienced today are directly traced back to the 1980s. The 1980s started a pattern of growth in profits for the American financial-services industry, which may just now come close to an end. The article explains to us that during this time, the profits did not come from the increasing asset prices or the falling interest rates. They were able to make profits and remain strong for so long by using the debt from the dotcom bubble burst as a way to increase profit and income. Banks made a lot of money by trading these debts with each other, only to find out that they really were not worth much at all.
The reason why the failure of investment banks like Bear Stearns are so important to understand and research are to find how to make sure other banks do not experience the same outcomes. Ben Bernanke and the Federal Reserve made plans to supply Bear Stearns with adequate money to stabilize and keep from filing bankruptcy. Now, Bear Stearns has been bought out for pennies on the dollar. This should stand as a sign to other Banks about how they should and should not conduct business. This should also be a sign that the financial services industry needs to be watched more closely. If more supervision is not provided, more financial institutions could experience the same failures, resulting in harm to the American economy and the pocketbooks of the American people.
This article is about Bear Sterns failures, Wall Streets fifth largest investment bank and its correlation to the financial system. Reasons for the failure are connected to fact that their institutions was getting by without check ups or regulations. This increased the possibility of fraud and many other deceitful tactics. This was all because many managers were focused on short-term gains with disregard for long-term consequences. Their principle was in the event of disaster, someone else would bear the losses.
The article goes on to talk about how finance has changed over the past decade because of the use of euro-dollars, collapse of the Bretton Woods system, and a series of oil shocks. This all lead to an increase in investment in markets and caused instability around the word. This instability not only affected markets, it affected industries (such as Bear Sterns). When economic growth slows, shareholders and taxpayers lose tons of money. Now there are some solutions to this process. One could be to increase CAR (capital, adequacy, ratios). So banks could hold more equity to soften the blow of falling asset prices.
The Bear Sterns case is important to understand so that these outcomes can be avoided. There were plans to supply the company with enough to stabilize and keep them from filing bankruptcy. In class we talked about how investment banks losses are paid by tax payers. This should teach individuals and corporations that looking ahead, in some cases, is most important. Companies should not sacrifice ethics for a quick buck. Anything that may cause the company big losses in the future should be avoided. I’m sure Bear Sterns can attest to that.
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