Brave World: Investment Banking 2008 (B):KEL380) Why

¶ … brave world: Investment banking 2008 (B):KEL380)

Why were proponents of deregulation so successful in the late 1990s? How much can we blame deregulation for the meltdown in the investment banking industry? And how could the government have foreseen and/or stopped the domino effect before the crisis of 2008?

Proponents of deregulation were successful due in part to increase wealth of American citizens. Housing prices were rising at an incredible pace. Many Americans were becoming wealthy by simply "flipping" houses on the market. With this wealth, came an increase in prosperity and a standard of living for many Americans. However, this practice soon came to an end when the housing market bubble burst in late 2006. Much of the blame can be attributed to the greed of the investment banking and financial institutions. Investment banks were essentially giving loans to individuals who could not afford the payment. In turn, the investment banks such as Morgan Stanley and Goldman Sachs assumed large of amounts of debt. When large amounts of delinquencies and foreclosures occurred, investment banks didn't have sufficient capital to cover the losses ("Subprime Crisis: A timeline" 2008). The government fostered this behavior by providing insurance for these securities. With government backing, subprime loans were given to individuals in staggering numbers. Eventually, these individuals could not afford to make the payment and defaulted. The government could have foreseen and slowed these practices by created higher standards for home ownership. However, legislation before the crisis would be unpopular for politicians looking to get reelected. Politics plays a significant role within these circumstances. Property owners, the financial services industry, and investment bankers were all reaping the benefits of a housing market appreciating at nearly 58% a year from 2000 (AOL Real Estate Staff, 2010). A decision to halt such a rapid increase in wealth would have adverse consequences for the politicians and bankers involved. Politicians on one hand, wanting to get reelected would be seen as unpopular if they slowed the rapid increase in property values. Bankers, on the other, could essentially lose their jobs for attempting to halt unethical policies of investment banks.

2. How much of the industry-wide crisis stemmed from investment banks' financials and current economic climate as opposed to investor panic and speculation?

The crisis stemmed from both investor panic and investment bank financials equally. For example, near the height of the crisis, Bear Sterns, who ultimately was allowed to go bankrupt, had nearly $17.4 Billion in cash and cash equivalents ("Edgar online," 2008). However, it was too heavy burdened by the subprime mortgage market. Many trading counterparts did not want to deal with the risk associated with lending to Bear Sterns who was severely exposed to the mortgage industry. Also, hedge fund managers, who held significant positions within the bank did not want to deal with the risk associated with Bear. Hedge fund managers, who have an obligation to the individuals who invested in the fund, don't want to jeopardize their returns with unnecessary risk. As a result, they withdrew funding which had a systemic effect on the market. As soon as one predominate hedge fund manager withdraws money, other managers may soon do the same. What results is a mass bank run which had a significant impact on Bear. So much so, that its "well capitalized" position was compromised. In addition to subpar financials, investors were bombarded with huge amounts of negative publicity about the financial service market, which caused severe unrest. Investors hurried to sell stock in hopes of salving any further loss that they believed would undoubtedly occur. Bear owned more subprime securities between 2004 and 2007 than any other financial institution in America. Many other financial institutions were more diversified in terms of product offerings and business locations. Wells Fargo, for example, acquired Wachovia and its investment banking department in the midst of the financial crisis.

3. Could Morgan Stanley and Goldman Sachs survived without becoming bank holding companies? What were the benefits and disadvantages of becoming bank holding companies? What does designation as bank holding companies mean for the way Morgan and Goldman operate going forward?

Both Morgan Stanley and Goldman Sachs could not have survived without becoming bank holding companies. Both companies, like Bear Sterns earlier, were too heavily burdened with subprime mortgages. However, unlike Bear Sterns, Goldman starting short selling the housing market securities in 2007(Blodget, 2010). As a result, Goldman Sachs generated billions in revenue. This however, was not enough to offset the trillions lost in the sub-prime mortgage crisis.