2008 Financial Crisis: Collapse of Bear Stearns and Lehman Brothers

Orcun Kahyaoglu

The Bear Stearns Companies, Inc. based in New York City, was a global investment bank and securities trading and brokerage firm, until its sale to JPMorgan Chase in 2008 during the global financial crisis and recession. Its main business areas, based on 2006 net revenue distributions, were capital markets (equities, fixed income, investment banking; just under 80%), wealth management (under 10%), and global clearing services (12%).

Lowenstein states in his book that Bear Stearns was involved in securitization and issued large amounts of asset-backed securities, which in the case of mortgages were pioneered by Lewis Ranieri, "the father of mortgage securities" (2010).

There are some major causes that made the Bear Stearns collapse. The rumors about running out of cash made people loosing confidence. Then, they want their money out which could cause the rumor to become true. But the securitization of subprime mortgages, which are called toxic assets, was the main cause of Bear Stearns to collapse. Bear borrowed too much to invest in these toxic assets and it should have found more lenders to loan money to Bear.

The moral hazard issue is again on its work in the financial markets. It is a term that is the encouragement to take risky or reckless action that arises when your losses are insured by someone else (Quiggin, 2008). If a company is bailed out, it may make the same mistakes again and if the company was allowed to fail, this may create a great systematic risk.

Tim Geithner learned that Bear had made credit default swap deals worth trillions of dollars all over Wall Street and around the world. Because Bear Stearns was so indebted to so many other people, their failure to repay their debts, or pay their debts, would cause a cascade of other failures, and it was frighteningly interconnected with other banks in Wall Street. Geithner saw that central bankers most fear from systemic risk. Bear Stearns, Geithner concluded, was “too big to fail.” A bankruptcy could undermine confidence in every major Wall Street firm.

 

Because of the issue of moral hazard, Lehman Brothers allowed to fail. Moral hazard concern of federal government surpassed systematic risk and they decided to not bailout. But the decision seemed to be wrong in the following days. Systematic risk become real and none of the banks lend to each other even if they know well the inter-bank lending is the bedrock of the banking system.

Mortgage crisis became a general credit crisis with frozen credit markets after the banks had stopped lending. Investors were shaken by Lehman’s bankruptcy. Commerce in America was grinding to a halt. The world’s largest insurance company AIG was down 70%. Geithner realized that if AIG went down, the consequences would be even worse than Lehman, so he argued for another bailout. He punished the banks that were parties in AIG’s toxic deals by making them take a financial hit. He made the parties have to take a discount on their insurance policy with AIG. As a result, government initiated a full-scale bailout of the U.S.’s financial system by taking stakes in the largest banks in U.S.

Lowenstein, R. (2010). The End Of Wall Street, Penguin, pp.xvii,22

Quiggin, J. (2008). Moral Hazard, Meet Adverse Selection. Retrieved from: http://crookedtimber.org/2008/09/19/moral-hazard-meet-adverse-selection/

2008 Financial Crisis: The Story of IndyMac

Orcun Kahyaoglu

IndyMac was born in 1985 and originally called Countrywide Mortgage Investment by David Loeb and Angelo Mozilo. It began as an Investment Bank. It was built to collateralize Countrywide Financial loans that were too large to be sold to Freddie Mac. In 1997, Countrywide Mortgage Investment became IndyMac. The Mac in IndyMac is short for Mortgage Corporation. In 1999, IndyMac Bank was the ninth largest bank at the time and was also the 28th biggest lender in the country. In 2004, IndyMac bought Financial Freedom, which was creating and servicing reverse mortgage loans. In 2007, IndyMac made two more acquisitions, which were New York Mortgage Company and Barrington Capital Corporation (Devcic, 2009).

There are two main reasons that led the downfall of IndyMac. One of the biggest reasons it came crashing down is the questionable loans and the other one that helped IndyMac get there is the reverse mortgage businesses.

IndyMac specialized in what are known as Alt-A loans. Alt-A loans are less risky than subprime loans but they are riskier than prime loans. In 2001, 2% of the overall U.S. mortgage market was accounted by Alt-A loans with $55 billion in loan productions. Through five years, in 2006, these loans reached to 13% of the overall U.S. mortgage market with a staggering $400 billion in loan production. These loans formed the 80% of IndyMac’s business that made it the number one lender in Alt-A mortgages (Devcic, 2009).

Reverse mortgages is a type of loan that a homeowner can allocate a part of the house asset into cash while keep staying at home. Leviton states that reverse mortgages have been suggested as a promising financial tool to help low-income older homeowners who want to remain in their houses. However, actual use of this option has been much below early estimates of potential demand (2002). The collapse in the housing market made the investors stay away from the loan pools. Therefore, IndyMac could not find the money to pay the cash. The peak in the stock prices of IndyMac in 2007 was the start of the falling point of the bank. Devcic described the situation that “In April of 2008, both Moody's and Standard and Poor's downgraded the ratings of IndyMac's mortgage-backed security bonds. By that summer, the credit crisis was all over the news, housing prices were collapsing and IndyMac was in big trouble” (2009).

So the summary of the situation is that suppose the bank has $1,000,000 and by being a bank it has the right to spend $9,000,000 on mortgages with its $1,000,000. But the point here is it has only the right, it is not certain whether can afford it or not. Moreover, it is not easy to afford the $9,000,000 value mortgages when they worth $5,000,000 after a while, and it is nearly impossible to afford when the main source of $1,000,000 is coming from real estate.  

The difficulty for finding funds causes IndyMac searching more on deposits to fund its mortgage originations. But the mortgages that could not be securitized created losses. The net loss in the first quarter of 2008 is $184,200,000 (Barr, 2008). These mortgages, which could not be securitized majorly formed from sub-prime securities. These securities blocked the liquidity and cause the demise to become closer for IndyMac.

During the period, investment banks bought mortgages from originated institutions. The rating agencies rates the Investment banks’ CDOs higher than they deserve, the financial engineers make the values of these CDOs higher with impractical inputs. Then, the CDOs were sold to investors. These kind of unethical and criminal activities involved in and cause the crisis later on.

Gramm-Leach-Bliley Act of 1999 is an extremely important piece of legislation in that it removes many longstanding restrictions against affiliations among banks, securities firms, and insurance companies and thus sets the stage for dramatic changes within the financial industry. The act also establishes a regulatory framework under which bank, securities, and insurance regulators supervise their respective activities within a financial holding company, while the Federal Reserve serves as “umbrella supervisor” over the entire organization (Spong, 2000, p. 33). This act creates an additional difficulty for IndyMac to cope with the demise.

It is stated in Los Angeles Times that “Federal authorities estimated that the takeover of IndyMac, which had $32 billion in assets, would cost the FDIC $4 billion to $8 billion. Regulators said deposits of up to $100,000 were safe and insured by the FDIC. The agency's insurance fund has assets of about $52 billion” (Kristof & Chang, 2008). It was a very controversial issue whether a government bailout for the bank would create a moral hazard or not and if the government did not touch the bank, would there be any systematic risks. The government and IndyMac agreed on a new business plan that if the bank could not access a new capital, it had to stop making new mortgages to shrink its balance sheet and meet the goal of improving its capital ratios.

After a while, OTS did an audit and decided that IndyMac was not stable enough to continue serving as a viable bank. As a result, OTS made a recommendation to the FDIC to take over IndyMac and move it out into bankruptcy (McGlasson, 2009). FDIC split the bank into two and moved all the good assets in one part and sold that part to OneWest Bank.

To conclude, the high-risk loans, unrealistic rates, securitization problems and falling home prices were the main reasons of the demise of IndyMac. If the necessary precautions were taken on time, there would not be any frustrating results. This is the evident that even such huge institutions like IndyMac may come to an end. 

Barr, A. (2008). IndyMac Deemed Under-capitalized by Regulators. Retrieved from: http://articles.marketwatch.com/2008-07-08/news/30771107_1_indymac-shares-indymac-bancorp-chief-executive-mike-perry

Devcic, J. (2009). Too Good To Be True: The Fall Of IndyMac. Retrieved from: http://www.investopedia.com/articles/economics/09/fall-of-indymac.asp#axzz1wanE6IHi

Leviton, R. (2002). Reverse Mortgage Decision-Making. Journal of Aging & Social Policy, 13(4).

Kristof, K. M., & Chang, A. (2008). Los Angeles Times. Federal Regulators Seize Crippled IndyMac Bank. Retrieved from: http://articles.latimes.com/2008/jul/12/business/fi-indymac12

McGlasson, L. (2009). IndyMac: The Inside Story of a Bank Failure and Rebirth. Retrieved from: http://www.bankinfosecurity.com/indymac-inside-story-bank-failure-rebirth-a-1432/op-1

Spong, K. (2000). Banking Regulation: Its Purposes, Implementation, and Effects (5 ed.). Kansas City: Federal Reserve Bank of Kansas City 

2008 Financial Crisis: First Signals

Orcun Kahyaoglu


The main reasons of the financial crisis are the overrated securities and the borrowers’ incapability of paying. There were no verification of income or assets of the borrowers. Moreover, the securities were rated as they were not that much risky. Securitization of these high-risk sup-prime mortgage loans would bring the end of U.S. financial system unless the government helped the institutions. No one predicted that a recession could have destroyed $11 trillion of Americans’ net worth.

The Wall Street Side

Wall Street stands for big businesses, financial institutions and corporations while Main Street refers to small businesses, locally owned businesses and banks. In the movie it says Wall Street is greedier than Main Street. Skousen states “Wall Street is not Main Street. In other words, the business of investing is not the same as investing in a business.” (2007). Americans also think that government rescued Wall Street and had more concentration on Wall Street than Main Street. 

In 2008, the Wall Street risks started to take actions. The ones who realized that credit derivatives could be used to trade loan risks is the J.P. Morgan team. That idea was thought to make the financial system safer. This will create big problems later. The collateralized debt obligations (CDO), synthetic CDO's, credit default swap, and predatory lending were the major tools of the financial institutions in those years. Lloyd Blankfein, CEO of Goldman Sachs states that a CDO is a pool of assets that can be sliced and in a synthetic, you pool reference securities that are indexed to specific more pools of mortgage. On the other hand, by credit default swap, many investors were able to invest in some entities that they had not had access to before. This was a new creation, which brought a broad change in the entire marketplace. People tried to create something that has a high rating and a high yield. Moreover, the mortgage lobby opposed the legislations about predatory lending. The chance of avoiding the drawbacks of these predatory mortgages has passed in the early 2000s. 



Everything started to go wrong and a government reform on the problems was needed at that time. That’s why the Glass-Steagall Act was repealed. 



Skousen, M. (2007). Forbes. Wall Street vs. Main Street. Retrieved from: http://www.forbes.com/2007/10/31/book-­‐excerpt-­‐investing-­‐oped-­‐ cx_ms_1101skousen.html

The Giant Pool of Money in US Credit Crisis

Orcun Kahyaoglu


The global pool of money is all the money spent in every country on Earth in a year and currently it is $70 trillion but in the year of 2000 it was $36 trillion.

Fed held the interest rate at a very low level %1 that did not attract the investors waiting to invest the giant pool of money into low risk high return investments like US Treasury bonds.

Homeowners were paying %5 to %9 to borrow money from banks at that time. But for a giant pool it is not possible to handle with people one-by-one. So a way was formed to use the pool. The mortgages were bought from a broker and sold to small banks. Then the banks sold these mortgages to Wall Street’s large investment firms. So huge amounts of mortgages were collected by these firms to be sold as mortgage-backed securities to the giant pool’s investors (The Giant Pool of Money, 2008).

The biggest problem is that they trusted credit rating agencies’ grades. The grades indicated that the mortgage-backed securities were as safe as the US government bonds. But in real they were not. The mortgages were given without checking the payment capabilities of people.

These unsafe high-risk securities called toxic waste were going to create a real trouble in following periods, which is crisis.

This Is American Life. (2008). The Giant Pool of Money. Retrieved from: http://www.thisamericanlife.org/radio-archives/episode/355/transcript

A Brief Description of US Financial Regulatory System

Orcun Kahyaoglu


The major regulators are Office of the Comptroller of the Currency (OCC), Office of Thrift Supervision (OTS), and National Credit Union Administration (NCUA).

What do they regulate?


Office of the Comptroller of the Currency regulates chartering, licensing, branching both intra-state and interstate, mergers-acquisitions-consolidations both intra-state and interstate, supervision and examination, prudential limits-safety-soundness and the consumer protection’s enforcements of National Banks and Federal U.S. Branches and Agencies of Foreign Banks.

Office of Thrift Supervision regulates chartering, licensing, branching both intra-state and interstate, mergers-acquisitions-consolidations both intra-state and interstate, supervision and examination, prudential limits-safety-soundness and consumer protection’s enforcements of Insured Federal Savings Associations and it regulates Insured State Savings Association by all of the above except chartering and licensing regulations. OTS also regulates Savings Association Holding Companies as the same as Insured Federal Savings Associations with the exception of consumer protection’s enforcement.

National Credit Union Administration regulates chartering, licensing, mergers-acquisitions-consolidations both intra-state and interstate, supervision and examination, prudential limits-safety-soundness and the consumer protection’s enforcements of Federal Credit Unions. It also regulates mergers, acquisitions and consolidations of State Credit Unions.

Financial regulation’s complexity

Mishkin states that in order to increase the information available to investors and ensure the financial system’s soundness; the government regulates financial markets and intermediaries. He also adds “Regulations include requiring disclosure of information to the public, restrictions on who can set up a financial intermediary, restrictions on what assets financial intermediaries can hold, the provision of deposit insurance, reserve requirements, and the setting of maximum interest rates that can be paid on checking accounts and savings deposits.” (2012, p. 9). All these interrelated regulations and decentralized power seeking and the most significantly federalism make the financial regulation so complex.

Mishkin, F. S. (2012). The Economics of Money, Banking, and Financial Markets (10^th ed.). New York: Pearson. 

Behaviors of the Underclass and Dysfunctional Culture

Orcun Kahyaoglu

Wilson’s underclass theory emphasizes external causes to be the determinant of the underclass behavior. In his explanation, Wilson identifies that a change in availability of opportunities would override what is seen as deviant behavior due to cultural dysfunction. Availability of job opportunities and positive external causes would change the cultural norm that is attributed to underclass deviant behavior (Schiller, 2008).

While comparing parents’ aspirations and expectations for their children’s opportunities for employment, Wilson’s research observed that parents from impoverished families have high aspirations for their children securing respected jobs but minimal expectation that they will reach those aspirations. There is the dysfunctional culture that is created by belief that there are no chances for success within the underclass society. However this culture can be changed if the expectations would match the aspirations. 

While collecting responses of students from poor and non-poor families on their expectations to complete college education, Wilson’s research observed that students from both the poor and non-poor families had high aspirations to complete college education. However, only a reduced percentage of students from the poor families actually complete the college education as compared to children from non poor families (Schiller, 2008).

Pedersen (2002) explains behavior therapy, which seeks to train individuals on how to interact with cultural influence on behavior. Dysfunctional culture acts only as a status quo in determining the deviant behaviors of underclass. If external causes would be brought in to influence or help the underclass attain their aspirations and expectations, they would deviate from the acclaimed dysfunctional culture. Dysfunctional culture is created by the repeated inability to attain the expectations meaning if the expectations could be attained, then the whole cultural setting would change resulting to a positive change in behavior.

Pedersen, P. B. (2002). Counseling across cultures. Thousand Oaks [u.a.: SAGE.

Schiller, B. R. (2008). The economics of poverty and discrimination. Upper Saddle River, NJ: Pearson/Prentice Hall.

The FED’s View of Current State of The US Economy

Orcun Kahyaoglu


Fed’s most recent monetary policy is the dual mandate. The committee seeks to foster maximum employment and price stability. These actions are necessary to expand economy moderately.

Dual mandate refers to promote effectively the goals of maximum employment, stable price and moderate long-term interest rates (Federal Reserve Bank of Chicago, 2012). The unemployment rate part is more of a concern for the Fed at present. The high oil and gasoline prices at the first months of 2012 is expected to have a temporarily effect on inflation and it will run at or below the rate that it judges most consistent its dual mandate (Federal Reserve, 2012, para. 2).

The US economy has been expanding moderately. The unemployment rate has declined but remains lifted up. There is a continuity to advance for household spending and business fixed investment. The housing sector remains depressed. Recent inflation rate is high because of the high prices of crude oil and gasoline but in the long-term it remains stable (Federal Reserve, 2012, para. 1).

It is a common issue to compare the experiences of Japan in the late 1990s to recent US monetary policy. So there is this view circulating that the views Ben Bernanke, the Chairman of Federal Reserve, expressed about 15 years ago. On the bank of Japan are not inconsistent with US policies. His views and the policies today are completely consistent with the views that he held at that time. He made two points at that time to the Bank of Japan. The first was that he believes that a determined central bank could and should work to eliminate deflation that is, falling prices. The second point that he made was that when short-term interest rates hit zero, the tools of a central bank are not exhausted, there are still no other things that the central bank can do to create additional accommodation. The current situation in US is that US is not in deflation. When deflation became a significant risk in late 2010, they used additional balance sheet tools to help return inflation close to the %2 target. So the difference between the Japan situation in the late 1990s and US situation today is that Japan was in deflation and when there are deflation and recession, then both sides are demanding additional accommodation. On the contrary, US’s policy is extraordinarily accommodative (Bernanke, 2012).

Bernanke continued to explain the problems with the current deficit. An increase in the interest rates will affect government debt payments that can cause budget deficits. Bernanke asked Congress to deliver a spending plan that included putting the deficit on a sustainable path to recovery, but not at the expense of the fragile economic recovery (Forbes, 2012).

The Fed responds to the “Too Big To Fail” problem that they are increasing supervisory and regulatory oversight of large financial institutions.  Fed also tries to eliminate the problem by allowing failing of large complex financial firms, which come to the brink of failure.

Bernanke, B. (2012). Press Conference with Chairman of the FOMC, Ben S. Bernanke [Video tape]. United States

Federal Reserve. (2012). Press Release. Retrieved from: http://www.federalreserve.gov/newsevents/press/monetary/20120425a.htm

Federal Reserve Bank of Chicago. (2012). The Federal Reserve’s Dual Mandate. Retrieved from: http://www.chicagofed.org/webpages/publications/speeches/our_dual_mandate.cfm

Forbes. (2012). Bernanke: Sacrificing Price Stability For A Few Jobs Would Be ‘Reckless’. Retrieved from: http://www.forbes.com/sites/afontevecchia/2012/04/25/bernanke-sits-on-a-fence-qe-on-the-table-but-dangerous/