The Wall Street's Catastrophe

STRESSED UP. The crash of Wall Street mounts pressure on United States Treasury Secretary Hank Paulson, as he faces challange to get rid of what is dubbed as one of the greatest economic disasters ever happens in United States

The New York Wall Street, as is recognized as the most prominent stock market worldwide in which stock markets like NASDAQ and Dow Jones reside, is in turmoil. It is, in fact, the main pointer of all stock markets as well as financial systems all over the world. Now analyze this: September 30, 2008 Wall Street was hammered when the Dow industrial average index fell 778 points –a record for one-day decline. Then, the record was surpassed a week later, it fell 800 points, leaving investors, bankers, and economists conjecture, “How dire this crisis will turn out to be?”

This financial meltdown comes out of the blue, unforeseen, and highly unexpected. When Alan Greenspan left his post as the Federal Reserve’s chairman in 2006, at that time no one would ever believe that what awaited his next successor is this huge economic mess, with great responsibility to fix it. During Greenspan’s period in office, for years United States experienced terrific times on its economy like a relatively low inflation rate, boosting house prices, escalating firms’ profit, and so forth. But suddenly, coming out from nowhere, here goes the downturn.

And so emerged his heir, Ben Bernanke, to whom many people throw these words at present, “Wrong time to be a governor of The Fed, Sir”, the words that may also resound in a similar way within the mind of Henry M. Paulson Jr., an ex Goldman Sachs’s CEO who took the chair of US Treasury Secretary in 2006. Both Bernanke and Paulson share the same task: they did not shatter the economic framework, but they have to mend it nevertheless.

The words that were delivered by Mark Gertler, a New York University economist, regarding current financial crisis in United States are absolutely terrifying: This is the worst financial crisis since the Great Depression, no doubt about it. As we recall the Great Depression of 1929, it is no exaggeration to say that those times are the nastiest of all economic breakdowns ever happened in any part of the world, where many banks in United States collapsed and then followed by the crash on the world’s stock markets. As a matter of fact, what we experience today look a lot like it. Currently we are witnessing the event that will be remembered by next generation’s economists and written in all economic textbooks; the story about how United States blew its economy up and failed to save its citizens from the outburst.

The derivations: what rocks Wall Street, and why it happens

The saga started with the bankruptcy of Bear Sterns, followed by Federal Home Loan Mortgage Corporation (Freddie Mac) and Federal National Mortgage Association (Fannie Mae), then the story reached its climax; the collapse of Lehman Brothers. As is well-known, Bear Sterns is the fifth biggest investment bank in United States, Freddie Mac and Fannie Mae are huge financial companies working on mortgage-lending business, and Lehman Brothers is the foremost among them: the nation’s fourth-biggest financial institutions with over 25,000 employees and the sum of its assets calculated more than US$ 600 billion.

In the Wall Street, there are several renowned financial institutions that are considered as big players on the floor, whose stocks are traded at towering price because of their reputation and eminence. When we mention names like Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers, and Bear Sterns, we are talking about quality and excellence they have built through long-time affiliation with their clients. These financial institutions became a dream workplace for students in famous business school like Harvard or Wharton –before this disaster happens.

And there is this word: sub-prime mortgage, the nucleus of all of these problems. In reality, there are two types of mortgage. The first one is prime mortgage, credit given to large firms and institutions which usually use it as source of capital. A prime mortgage tends to have low risks; the lenders will likely be able to fulfill the obligation to return the money and the debt has small possibility of being unpaid. The second one –well, this word is getting famous nowadays–, is the sub-prime mortgage, the one that banks give to people in common or small businesses. It is defined easy, suppose you go to the bank to borrow some money, then the money that the bank gives you is the sub-prime. Of course, because we, as normal people, borrow money because we urgently need it, we will not do careful calculations and estimations –as large firms and institutions do when they borrow money– regarding can we really return the money we borrow. Even sometimes, because of pressing circumstances, we just borrow the money and speculate on our ability to return it. So if banks know that sub-prime mortgage tends to have high risk, then why give people sub-prime instead of prime mortgage? And how does this simple problem emerge chaos in one big financial system like United States’?

The Financial Accelerator Model is the answer of the question number one. This theory argues that financial condition and credit condition largely interrelated with economy, and both sides support each other. In fact, the condition of these three variables could be the main factors to generate economic booms, or conversely, economic failures. Economic booms cause firms and family units have higher income –and higher value of their assets as well. With higher value of assets, banks will likely be more generous to lending credits to them. Easy lending promotes easier lending requirements, therefore, produces more money to the market and accelerates economic growth, vice versa. However, the sub-prime mortgage controls the market for money lending, and most of the demand for credits given by the banks is usually on the type of sub-prime, very few is prime mortgage. That's why sub-prime mortgage holds an important role in the economy. It is, in fact, a fundamental variable in one country’s economy.

Laissez-Faire is the answer of the question number two. Yesterdays, there was too much freedom given to Americans who want to borrow money from banks. No collateral, no need to guarantee, and no further supervision to the borrower; it was even said that an American who borrow the money and had not returned it for years got no words of warning from the bank at all. As a result, Americans felt free to borrow money as the requirements from banks made borrowings seem easy. Also, United States is a liberal country which supports the invisible hand ideology; the less government intervenes, the better financial system and economy works. But, here is the correction. If truth be told, that lack of supervisions and regulations has actually worsened the situation. That Laissez-Faire thing has emerged greed among the market –financial institutions work as they please as there is no regulation to prevent them to do so.

Here is how greed is defined. Imagine yourself as Richard Fuld, a failed CEO of Lehman Brothers, a bank that works on mortgage and credit lending business. During period 2001-2005, United States experienced a bubble in housing market, where demand for houses largely increased that caused the price to accelerate. As we normal people assume that house price will continue to go up and up and never plunge, then there goes the bandwagon effect; investing money in house will become trend among American people and creates a larger boom in house demand. So as the demand for houses increased, so does the credit and the mortgage –people ran to the banks to get credit to buy houses. Therefore, the demand for credit –the subprime– also increased. The demand for credit boosted significantly, but unfortunately, Lehman Brothers do not have enough money to supply the credit’s demand. What would you do as a CEO?

In actual fact, Richard Fuld is a very ambitious person. What he did as Lehman’s CEO was he tried to match the credit’s demand by piling up debt; he continued to borrow and borrow money and made sure that Lehman was still able to supply the money into the market. Well, huge investment? Wrong. It was one hell of a risky business. Soon as the housing bubble burst and house price fall, Lehman Brothers took a punishment because of its greediness: it went broke. Lehman could not recover most of its assets because many borrowers found that their houses were worth far less than their mortgages, thus, they could not afford to reimburse the credit.

The illustration for the derivations of this financial crisis can also be described in a more simple way. It began with the housing bubble. Second, the housing bubble led to a massive increase in credit –the sub-prime mortgage– demand. Then due to the increase in sub-prime mortgage demand, financial institutions burdened themselves; they piled up their debts by borrowing before lending it again for the sub-prime borrowers who used the credit to buy houses. When the housing bubble burst, the house price fell, and many borrowers were not able to pay back the money, those financial institutions took the upshot: they got busted. And that’s the way it is done.

The present time: daunted by the domino

The fall of Lehman Brothers is not the last part of the story and it is important to study its collapse to analyze the roots of the crisis, as well as the forthcoming effects in the future. In fact, the repercussion of Lehman’s fall is still there and even broadens; many financial institutions also went bust, and it encompasses names like American International Group (AIG) and Merrill Lynch. Those names are recognized as giant financial institutions in United States whose stocks conquer Wall Street, and the tumbling of the giants, which previously seems impossible, gives signal to the world that United States’ economy is in a real hazard.

In extraordinary circumstances, a central bank can act as the lender of the last resort, which is lending money -a bailout- to insolvent banks or financial institutions, if it thinks such action is necessary. That is what United States’ central bank, the Federal Reserve, did to Bear Sterns, Freddie Mac, and Fannie Mae; the Fed lend them some money so they can avoid bankruptcy. Unfortunate for Lehman Brothers, it is a different story since the Fed has made an absolutely clear statement: there will be no bailout this time.

Why no bailout? “Too many bailouts”, said the Fed. After the bailouts on Bear Sterns, Freddie Mac, and Fannie Mae, the fed thinks that giving bailouts over and over again will affect the morale of financial institutions in United States. If it gives bailout so easily, concerns are mounting regarding the morale hazard effect; other big financial institutions will go bankrupt effortlessly knowing the Fed will give them bailouts if they go bust. The Fed also forecasted that the effect of the Lehman’s bankruptcy would not be noteworthy for United States, since most of the Lehman’s creditors come from Asia and comprise only a small number of American creditors.

It seems mistaken, yet the Fed changes its mind. After Lehman Brothers had failed, the debacle went to the next level; an insurance giant named American International Group (AIG) followed Lehman Brothers and went broke. Worried by the huge impact of the collapse of AIG, the Fed saved AIG and decided to give bailout once more to repress greater damage to the economy. End of the story? Far from it, then there is Merrill Lynch which went broke and had to be sold to Bank of America –thanks to Merrill’s CEO John Thain who succeeded the deal right before it were about to tumble. The collapse of AIG and Merrill Lynch may not be the last to bring the crisis to an end, as United States’ preeminent banks like Goldman Sachs and Morgan Stanley wait in the line to be the next cadavers.

What will the future be without Lehman? Lehman’s fall, undoubtedly, has established the crisis of confidence in the economy. Confidence is the engine of the financial system; investors and banks work together since they trust each other –they believe the cooperation will offer symbiosis that benefits both of them. Meanwhile, Lehman Brothers is a huge investment bank with 158 years of history, an impossible-to-fail bank; even the Great Depression of 1929 could not take it down. Letting Lehman Brothers to fail is a bold gamble by US Secretary Treasury Hank Paulson, risky bet as well, because the domino effect of the collapse of Lehman Brothers –that crisis of confidence– is so high that they affect financial sector not only in the United States, but also many countries all over the world.

The fall of a huge bank like Lehman Brothers makes people believe that “the economy is in crisis”. Therefore, it establishes huge concerns among investors and bankers; causing market’s confidence to fade and people to lost trust to the economy. People pull their money out from banks’ vaults and banks all over the world hold themselves to give credits. As a result, it impedes capital flow in the market; forcing many central banks like Bank of England and European Central Bank to inject short-term liquidity funds. Keep in mind, credit is the grease of the economy on which businesses and firms rely as their source of capital. A contraction of credit leads to a lack of capital in the market, a lack of capital causes a slowdown in economic growth, and finally, an economic slowdown guides the economy towards a recession. Also, due to the volatility of the global economy caused by the collapse of one huge bank like Lehman Brothers, investors are on a hostile and risky environment to invest their money or run business. Concerning that situation, many investors decide to withdraw or delay their investments. Things like these are the domino effects of the fall of Lehman and, regrettably, have caused more upset in the global economy.

The worse is yet to appear. For Americans, the situation is getting really dreadful currently as the domino effect enlarges and has taken financial institutions like Merrill Lynch, AIG, Washington Mutual, and Wachovia into the same part as Lehman’s. People, however, have sunk deeply in this crisis of confidence. Yet despite the US government has tried to tranquilize this situation by delivering a US$ 700 billion rescue package into the financial system, doubts still arise whether the bailout will succeed or not. Yes, it seems that Americans’ confidence has plunged to the lowest level –and that is not an easy problem to crack.

One question remains left unanswered. So, how dire this crisis will turn out to be? Truthfully, it is still unknown how deep the global economy will sink. Let’s be optimistic: people there at the Fed and Treasury, who are nothing but smart, are doing whatever they can to prevent the US economy –and the global economy as well– from plummeting any further. Instead, the right thing to ask now is, what can be learned from this crisis? Here in economics, we do study the history; we analyze cases like the post-world war hyperinflation in Germany, the great depression of 1929 in United States, the Asia’s financial crisis in 1998, and so on. Indeed, this financial crisis turns a new page in the history of economy, and presents a lesson to be learned.