Research Paper on the Current Economic Crises

FINANCE B601-051DECONSTRUCTION OF THE CURRENT ECONOMIC CRISISBERK GUNERI

Table of Contents

INTRODUCTION...........................................................................................................................2

CHRONOLOGY OF THE CURRENT ECONOMIC CRISIS.......................................................2

ECONOMIC CRISIS DECONSTRUCTED...................................................................................9

REASON 1: FANNIE MAE AND FREDDIE MAC................................................................10

REASON 2: THE COMMUNITY REINVESTMENT ACT AND AFFIRMATIVE ACTION IN LENDING............................................................................................................................11

REASON 3: THE GOVERNMENT’S ROLE IN SPECULATION.........................................12

REASON 4: THE TAX CODE.................................................................................................13

REASON 5: THE FEDERAL RESERVE AND CHEAP CREDIT.........................................13

REASON 6: TOO BIG TO LET FAIL......................................................................................13

FINAL THOUGHTS.....................................................................................................................14

WORKS CITED............................................................................................................................15

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INTRODUCTION

Many elements contributed to the creation of current economic crisis- aka “The Credit Crunch.”

The media widely publicized that the crisis was a result of greedy investor on Wall Street.

However, a close look at the problem reveals that government had a much bigger role than some

investors looking to make money quick by taking excessive risks or irresponsible use of credit.

This paper will briefly explain the reasons behind the current economic crisis and the

government’s contribution to it.

CHRONOLOGY OF THE CURRENT ECONOMIC CRISIS

To get a better understanding of when and what happened at the beginning of the current

economic crisis a list of major events, which led to subsequent recession of the U.S. economy, is

outlined below.

2008

Sept. 7: Fannie Mae, Freddie Mac Seized by Government

The U.S. government takes control of mortgage companies Fannie Mae and Freddie Mac,

which held about half of the country's mortgages. The move put the liability of more than $5

trillion of mortgages on the taxpayers.

Sept. 14: Bank of America Buys Merrill Lynch

Bank of America, the nation's largest bank, credit card company and mortgage lender, buys

Merrill Lynch for $50 billion. The purchase makes Bank of America the largest retail

brokerage.

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Sept. 15: Lehman Brothers Files Bankruptcy

After the firm reported $19.3 billion in revenue in 2007, Lehman Brothers was forced to file

for bankruptcy after it failed to find a buyer for its $60 billion in failing assets. The company

had been in business for 158 years.

Sept. 16: Government Gives AIG Emergency Loan

In exchange for nearly 80 percent equity stake in the company, the government announces it

will give insurance giant AIG an $85 billion emergency loan. The government said a failure

of AIG could be devastating to the already struggling economy and financial markets.

Sept. 17: Barclays Makes Deal With Lehman

After passing on buying Lehman Brothers before the firm filed for bankruptcy, Barclays -- a

British bank -- buys the company's North American investment banking and trading

operations.

Sept. 19: Bush Announces Bailout Plan

The Bush administration asks Congress for powers to execute a plan to buy bad debt and

mortgages.

Sept. 21: Goldman Sachs, Morgan Stanley Change Status

Goldman Sachs and Morgan Stanley get approval from the Federal Reserve to transform

from investment banks to bank holding companies. The change means the companies will be

regulated by the Federal Reserve, and will give them access to its emergency loan program.

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Sept. 29: Citigroup Agrees to Buy Wachovia's Banking Operations

Citigroup agrees to buy the majority of Wachovia's banking operations for $2.1 billion in

stock.

Sept. 29: House Rejects Bailout Package

The House of Representatives rejects the $700 billion rescue bill by a 228-205 vote.

Sept. 29: Dow Suffers Largest Ever One-Day Drop

The Dow falls 777.68 points to mark its largest one-day point loss in history. The decline is

spurred by the House of Representative's rejection of the $700 rescue plan.

Oct. 1: Senate Passes Bailout

The Senate passes an amended proposed bailout bill, putting pressure on the House to do the

same.

Oct. 3: Wells Fargo Tries to Acquire Wachovia

Days after Citigroup agrees to buy Wachovia's banking operations, Wells Fargo says it will

acquire the company for $14.8 billion in an all-stock deal, without government assistance.

This starts a battle between Citigroup and Wells Fargo for the company.

Oct. 3: House Approves Bailout, Bush Signs Bill After the House voted in favor of the

bailout 263-171, President George W. Bush quickly signed it. After the vote Bush said the

government "acted boldly" to prevent the Wall Street crisis from spreading, but said "our

economy continues to face serious challenges."

Oct. 6: Dow Drops Below 10,000

For the first time since 2004, the Dow Jones industrials dropped below 10,000. At one point

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during the day, the Dow was down 800 points before it rallied near closing to finish the day

down 369 at 9,955.50.

Oct. 8: AIG Gets another Loan from Feds

The Federal Reserve agrees to provide AIG with a loan of up to $37.8 billion, on top of the

$85 billion loan it received in September.

Oct. 9: Down Falls below 9,000

Financial fears caused the Dow to drop to below 9,000 for the first time in five years. The

Dow dropped almost 700 points to close at 8,579.19.

Oct. 10: Wells Fargo Wins Battle For Wachovia

Antitrust regulators clear Wells Fargo to acquire Wachovia.

Oct. 28: Dow Has Second-Largest Point Gain Ever

The Dow soars 889 points to reach the 9,065 level.

Oct. 30: Economy Shrinks in Third Quarter, Signaling Recession

The government says consumers cut back on their spending in the third quarter by the

biggest amount in 28 years.

Nov. 5: Economy Stumbles after Election

The Dow falls more than 400 points on renewed fears of a recession.

Nov. 10: AIG Gets Bigger Bailout

The government provides new financial assistance to troubled insurance giant American

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International Group, including pouring $40 billion into the company in return for partial

ownership.

Nov. 10: DHL Cuts 9,500 Jobs

Mail and logistics company Deutsche Post AG says it will cut 9,500 jobs and close all of its

DHL express service centers in the U.S. amid heavy losses in the market there.

Nov. 13: Jobless Claims Soar

The government says that the number of newly laid-off individuals seeking unemployment

benefits jumped more than expected last week to a seven-year high. The Labor Department

says jobless claims increased by 32,000 to a seasonally adjusted 516,000.

Nov. 13: Budget Deficit Reaches Record $237.2 Billion

The federal government begins the new budget year with a record deficit of $237.2 billion,

reflecting the billions of dollars the government has started to pay out to rescue the financial

system. The Treasury Department says the deficit for the first month in the new budget year

was the highest monthly imbalance on record.

Nov. 14: Bush Wants Give $25 Billion in Loans To Carmakers

The White House is throwing support behind a plan to speed release of $25 billion in loans

to troubled automakers but is rejecting a Democratic proposal to use money from a financial

bailout for car companies. Spokeswoman Dana Perino said the Democratic proposal would

lead to partisan gridlock because the $700 billion rescue package was never intended to help

automakers and shouldn't be now.

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Nov. 15: World Leaders Seek To Prevent Future Economic Crisis

World leaders are agreeing to flag risky investing and regulatory weak spots in hopes of

avoiding future financial meltdowns. President George W. Bush and leaders from nearly two

dozen countries endorse broad goals to fend off any future crisis and revive the economy.

They are pledging to lay the foundation for reform so that the kind of global crisis now

dragging down the economy does not happen again.

Nov. 19: Dow Drops Below 8,000 For First Time since 2003

Wall Street hit its lowest level since 2003. The Dow Jones industrial average fell below the

8,000 mark. It dropped nearly 430 points to 7,997. The news came as major automakers

await a decision from Congress about a bailout for their industry.

Nov. 20: Jobless Claims Rise

Labor Department reports that claims for unemployment benefits hit their highest level since

1992. The Labor Department said new applications for jobless benefits rose to a seasonally

adjusted 542,000 from a downwardly revised figure of 515,000 in the previous week.

Nov. 24: Citigroup Gets another Bailout

The government announces it is giving another $20 billion to Citigroup with the hope it will

keep the financial giant from collapsing. The government will guarantee as much as $306

billion of risky loans and securities backed by commercial and residential mortgages, and in

exchange, the government will get $7 billion in preferred shares of Citigroup.

Dec. 18: Mortgage Rates Drop to 37-Year Low

Rates on 30-year-fixed mortgages drop to their lowest levels in at least 37 years. The decline

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came as the Federal Reserve pledged to pour money into the mortgage market in an effort to

pump life into the U.S. housing market. According to Freddie Mac, the average rate on 30-

year fixed-rate mortgages dropped to 5.19 percent, which is the lowest rate since April 1971.

Dec. 19: GM, Chrysler To Get $17.4B In Loans

President George W. Bush says the government will rescue the troubled U.S. auto industry,

offering $17.4 billion in loans in exchange for concessions from carmakers and their

workers.

2009

Jan. 12: Obama: Rest Of Bailout Package "Imminent And Urgent"

President-elect Barack Obama's economic adviser tells Congress that the need for the

remaining $350 billion of the financial bailout package is "imminent and urgent."

Jan. 13: Citigroup, Morgan Stanley Merge

Citigroup Inc. and Morgan Stanley announce they are combining their brokerages. Morgan

Stanley is paying Citigroup $2.7 billion for a 51 percent stake in the joint venture.

Jan. 28: House Approves Stimulus Plan

Democrats push an $819 billion economic stimulus package through the House without a

single Republican vote in favor of the plan. The package is at the heart of President Barack

Obama's plan to stimulate the economy. The legislation includes an estimated $544 billion in

federal spending and $275 billion in tax cuts for individuals and businesses.

Jan. 29: Jobless Claims Hit All-Time High

The government says the number of people receiving unemployment benefits has reached an

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all-time high. According to the Labor Department, the number of laid-off workers continuing

to claim unemployment insurance for the week ending Jan. 17 was a seasonally adjusted 4.78

million, the highest since records began in 1967.

Feb. 4: Obama Caps Pay For Execs

President Barack Obama imposed a $500,000 pay cap on some senior executives whose

firms receive government financial rescue money.

Feb. 17: Obama Signs Stimulus Package

President Barack Obama signs a $787 billion package to revive the economy, saying the

measure represents the "essential work of keeping the American dream alive in our time."

Feb. 19: Dow Closes At Lowest Level in 6 Years

The Dow Jones industrial average ends at its lowest level in more than six years when it falls

to 7,466. It marks the lowest level since Oct. 9, 2002.

Feb. 23: Dow, S&P Close at Decade Lows

The S&P 500 index falls to April 1997 levels and the Dow sinks to October 1997 marks.

March 2: Dow Dips Below 7,000

The Dow Jones industrial average plunges below 7,000 for first time since October 1997.

(See Works Cited #1 for source information.)

ECONOMIC CRISIS DECONSTRUCTED

For years, public is told stories about the benefits to investment on a house. The general hype

was houses never lose value, it is the best investment one can make, and you make a lot of

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money by flipping houses. Politicians pumped up this hype in the name of creating an

“ownership society.” In other words, public saw or made to believe that the demand would be

always higher than the supply, therefore resulting in a constant increase in house prices. People

ignored the common laws of physics; this is all bubbles burst at one point if you continuously

pump air into it. One way to ignore this phenomenon is to reject the increase in house prices as a

bubble. Authorities assured the public that rising house prices was not a result of artificial

increase, but a result of healthy economy. Real estate is seen as a local investment; there could

be no event that would make the house prices fall across the entire country. Politicians

contributed the hype by enforcing lax standards for normally not qualified borrowers in the name

of increasing the home ownership rate of minorities and low-income families. These people

borrowed loans mostly on adjustable rates, which initially started with a low teaser rate and then

subsequently adjusted by the economic climate of the country. A negative change in the

economic climate brought an end to adjustable rate mortgage holders and the banks that lend

money to them.

REASON 1: FANNIE MAE AND FREDDIE MAC

Fannie Mae and Freddie Mac are created by Congress as “government sponsored enterprises.”

They enjoy special tax and regulatory privileges that potential competitors do not, but their stock

is traded on the NYSE. Their securities are designated as “government securities” and can be

held by banks as low-risk bonds. And for years, Fannie has had a special $2.25 billion line of

credit with the U.S. Treasury. (2) They do not directly lend loans to consumers, but purchase

existing loans and sell them on the secondary market to investors as mortgage back securities. In

other words, mortgage loans from different part of the country is purchased from loan originating

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institutions, bundled in a package and sold to investors by these two enterprises. The geographic

diversity of these types of bundles helps reduce the risks by making it less affected from local

price declines and defaults. Meanwhile, the originating bank, having received money from

previous mortgage obligations by selling to Fannie or Freddie, goes back to the market and lends

more loans to consumers. This cycle creates an artificial increase in home prices due to special

privileges these two companies enjoy by the help of government. Not only these two companies

generated their funds from government, but also they were seen as not liable to bankruptcy due

to the support extended to them from government as well. For years, this government guarantee

made it possible to these two companies to attract more investors and make higher offers to

existing mortgages.

On the other hand, politicians put increasing pressure on Fannie’s operations to lower credit

requirements on the mortgages they purchased from banks. Fannie Mae had been “under

increasing pressure from the Clinton Administration to expand mortgage loans among low and

moderate income people.” Even the Times understood the risk involved: “In moving, even

tentatively, into this new area of lending, Fannie Mae is taking on significantly more risk, which

may not pose any difficulties during flush economic times. But the government-subsidized

corporation may run into trouble in an economic downturn, prompting a government rescue

similar to that of the savings and loan industry in the 1980s. (2)

REASON 2: THE COMMUNITY REINVESTMENT ACT AND AFFIRMATIVE ACTION IN LENDING

The Community Reinvestment Act (CRA), a Jimmy Carter-era law, exposed banks to

discrimination lawsuits if they decline to lend loans minorities in satisfactory numbers. By using

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CRA, government agencies were pressurizing lenders into extending credit to riskier borrowers

in the name of “racial equality.” Being scared of discrimination lawsuits, lenders did what they

were told to do; extended credit to high default risk borrowers.

REASON 3: THE GOVERNMENT’S ROLE IN SPECULATION

When Fed flushed lenders with money, banks innovated lending practices such as “mortgages

with no down payments” to attract more borrowers. The new no down payment mortgage

holders are locked in to adjustable rate mortgages so that banks can share the risk with borrowers

in case of an economic down turn. However, mortgage defaults have increased in both sub-prime

and prime mortgage holders due to adjustable rates during the beginning of the crisis.

The explanation for the rise in foreclosures that makes sense of the available data involves

people who bought houses on a speculative basis, betting that their prices would continue to

increase. This category includes people who “flipped” houses, meaning they made various

improvements to houses and then sought to resell them at a high profit. It also includes people

who expected to make a profit by buying a house, waiting a short period of time, and reselling

for a profit based on the house’s appreciation. In recent years, speculative home buying has been

estimated at about one-quarter of all home purchases. Both kinds of speculators would be

attracted to the adjustable rate mortgage, since they intend to unload their houses well before the

teaser rate expires. When housing prices started falling just a little bit (only 1.4 percent in six

months starting in late 2006), foreclosures skyrocketed. With housing prices no longer on the rise

and the prospect of profit dwindling, many of these borrowers may simply have walked away.

Not having made any down payments made walking away all the easier. (2)

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REASON 4: THE TAX CODE

The current tax code includes incentives to own a home instead of rent. The biggest tax

deduction any family can make is home mortgage interest deduction from their income. This

code makes it attractive to buy. And to buy, most families borrowed loans from banks.

REASON 5: THE FEDERAL RESERVE AND CHEAP CREDIT

The Fed started the housing boom by increasing the money supply through the banking system

with the aim and the effect of lowering interest rates. (2) The Fed dramatically increased the

money supply in economy between 2000 and 2007. This new money and credit found its way

into the housing market, where artificially lax lending standards made excessive home purchases

and speculation in homes seem to many Americans like good financial moves. So the already

existing campaign to lower lending standards, along with the monopoly privileges enjoyed by the

quasi-government agencies Fannie Mae and Freddie Mac, played a role in channeling into the

housing market the new money the Fed was creating. (2) This new cheap money attracted many

speculators to housing market. On the other side, when banks lend out the money created by the

Fed, they lend it out to people who were not credit worthy. The result of this cycle is explained

in Reason 3.

REASON 6: TOO BIG TO LET FAIL

Certain financial institutions, such as Fannie and Freddie, had the luxury of operating with

confidence, because they would be always saved by the government in case of a catastrophic

failure. It was believed that their failure would create a chain reaction and bring the whole

economy down. Economist Antony Mueller explains this as: “Since Alan Greenspan took office,

financial markets in the U.S. have operated under a quasi-official charter, which says that the

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central bank will protect its major actors from the risk of bankruptcy. Consequently, the

reasoning emerged that when you succeed, you will earn high profits and market share, and if

you should fail, the authorities will save you anyway…” This confidence made these financial

institutions operate with over confidence and make riskier decisions, which led to economic

turmoil.

FINAL THOUGHTS

Many people including the mass media blamed free market and greedy investors for the reasons

behind the current economic crisis, but as seen from the reasons explained in this paper, the real

reason is government’s intervention with free market economy. I am not in favor of completely

abolishing Federal Reserve System, but the money that the Feds create should be better allocated

in other industries; the ones that create jobs and actually produce viable products. Saving money

should be encouraged by government so that banks can lend out money from the public’s savings

rather than the money created from thin-air by the Fed. U.S. should be shifted to production-

based society from service-based society. After all, you cannot consume, at least for a long time,

if you do not produce. Fannie Mae and Freddie Mac should be completely abolished so that

politicians’ intervention capacity with the free market economy would be avoided. In other

words, politicians should let the free market economy balance itself out through formation of

prices via natural supply and demand cycle. There is a proverb that describes the events that took

place before and during the current economic crisis; that is “You cannot operate a water fountain

with the water you carry from the lake every day.”

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WORKS CITED

1. Jr., Thomas E. Woods. Meltdown. Washington, DC : Regnery Publishing, Inc., 2009. 978-1-59698-587-2.

2. Internet Broadcasting. KiroTV. Timeline Of U.S. Financial Crisis: Recent Events In Struggling Economy. [Online] March 2, 2009. [Cited: April 4, 2010.] http://www.kirotv.com/money/17686933/detail.html.

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Documents

Research Paper on the Current Economic Crises