Financial Crisis of 2007-2010

Impact on Major Financial Institutions

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3. Impact on Major Financial Institutions

The International Monetary Fund (IMF) estimated that large U.S. and European banks lost more than $1 trillion from investments in toxic assets backed by bad loans between January 2007 and September 2009. These losses are expected to top $2.8 trillion from 2007-2010. U.S. banks’ losses were forecast to hit $1 trillion and European bank losses will reach $1.6 trillion. The IMF estimated that U.S. banks were about 60 percent through their losses, but British and Eurozone banks only 40 percent. A recession that is caused by the asset price bubble leaving many private-sector balance sheets with more liabilities than assets has been called the “balance sheet recession.” ^¹⁸

One of the first victims was Northern Rock, a medium-sized British bank.^¹⁹ It requested a bailout from the Bank of England. This in turn led to investor panic and runs on bank in mid-September 2007. Initially, calls for nationalization were ignored. In February 2008, however, the British government took the bank into public hands when no private buyer surfaced. Northern Rock's problems proved to be an early indication of the troubles that would soon befall other banks and financial institutions.

The first companies to be hit were those directly involved in the housing market like home construction firms and mortgage lenders who could no longer obtain financing through the frozen credit markets. Over 100 mortgage lenders went bankrupt during 2007 and 2008. The crisis peaked in September and October 2008. A number of major institutions failed, were acquired under duress, or were subject to government takeover. We discuss a few below.

3.1 Countrywide Financial

Countrywide issued about 17% of all mortgages in the United States in 2007. The California based company was founded in 1969 and its IPO was less than successful, trading over the counter at less than $1 per share. Between 1982 and 2003, Countrywide delivered investors a 23,000% return. Since its business was rooted in subprime mortgages, it faced collapse as a result of the financial crises, and was purchased by Bank of America in July 2008, and is now named Bank of America Home Loans.

3.2 Investment Banks: Bear Stearns, Lehman Brothers and Merrill Lynch

Three of the largest U.S. investment banks, Bear Stearns, Lehman Brothers and Merrill Lynch, were hit hard by the crisis and were either sold in emergency government backed acquisitions, or entered bankruptcy. Bear Stearns was on the brink of collapse in March 2008, when it was sold to JP Morgan Chase, with Federal government’s help. Lehman Brothers’ bankruptcy on September 15, 2008 marked one of the largest bankruptcies in U.S. history. It folded with record $613 billion debt.^²⁰ Barclays and Nomura Holdings bought up different parts of Lehman Brothers along regional lines.^²¹ The world’s largest brokerage firm, Merrill Lynch, was acquired by Bank of America in 2008 under distressed circumstances.

3.3 Bank Holding Companies: Washington Mutual and Wachovia

The largest bank failure in U.S. history is the collapse of Washington Mutual on September 25, 2008. It was placed into the receivership of the Federal Deposit Insurance Corporation (FDIC). Subsequently, the FDIC sold the banking subsidiaries (minus unsecured debt or equity claims) to JPMorgan Chase for $1.9 billion, and the remaining part of Washington Mutual filed for bankruptcy

The fourth largest bank holding company in the U.S. based on total assets, Wachovia, was arranged by the government to have it sold to Wells Fargo to avoid its imminent failure on December 31, 2008.

3.4 The GSEs: Fannie and Freddie

The Federal National Mortgage Association (FNMA) and The Federal Home Loan Mortgage Corporation (FHLMC), commonly known as Fannie Mae, and Freddie Mac respectively underwent massive changes as a result of the crisis. They are stockholder-owned corporations chartered by Congress during the 60s and 70s. The corporations’ purposes are to purchase and securitize mortgages in order to ensure that funds are consistently available to the institutions that lend money to home buyers, to buy mortgages on the secondary market, pool them, and sell them as MBS on the open market to help facilitate American homeownership through accessible financing. The secondary mortgage market increases the supply of money available for mortgage lending and increases the money available for new home purchases. As of 2008, Fannie and Freddie owned or guaranteed about half of the U.S.'s $12 trillion mortgage market.

On September 7, 2008, the Federal Housing Finance Agency (FHFA) announced that Fannie Mae and Freddie Mac were placed into its conservatorship. The action is one of the most sweeping government interventions in private financial markets in decades. By reassuring the soundness of the GSEs, the conservatorship resulted in MBS values receiving upward support, lowering borrowing costs for banks and owners of Fannie and Freddie debt and the Asian central banks specifically were protected. The common share stock prices of Fannie Mae and Freddie Mac plummeted however, wiping out a great deal of financial wealth, as shown in Figure 6.

Figure 6. Fannie Mae's stock price

3.5 AIG

Once the 18^th largest publicly traded company worldwide and part of the Dow Jones Industrial Average, AIG suffered from the credit crisis and ultimately required over $180 billion in government aid to avoid bankruptcy and its stock price dropped precipitously, as shown in Figure 7. In September 2008 AIG received their first credit line from the Fed in the amount $85 billion in an effort to help the corporation meet its increasing liabilities in the wake of its credit rating being downgraded to AA. In exchange, the Fed received a 79.9% equity stake in the firm.

In addition to direct assistance from the Fed and Treasury, the U.S. government also stepped in to purchase distressed assets owned or guaranteed by AIG. Even while selling off assets and subsidiaries, AIG managed to pay retention bonuses totaling over $160 million, drawing the ire of American public and Congress. Many employees even received hate mail and death threats^²².

Figure 7. AIG's Stock Price

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