Professor/Lecturer Ellmann's Course Materials Page

After the fall
economic thought
MBA/MA - Anglo-American University International Finance
ERASMUS - International Finance
MBA - Money and Financial Markets
ERASMUS Money & Banking
M.A. Public Policy Economic Sociology
On the Origin of Facts

After the Fall - What Happened, What's Next

Back from the brink.

The U.S. financial system last week was rocked by the biggest crisis since the 1930s - and the federal government responded with a multi-pronged intervention that is the most sweeping since the New Deal.

Over the course of just three days, Americans were shaken to see venerable investment bank Lehman Brothers Holdings file for bankruptcy protection, Merrill Lynch abruptly sell itself to Bank of America and the U.S. hurriedly launch an $85 billion bailout of American International Group, one of the world's largest insurers. Just one week earlier, the government had bailed out mortgage giants Fannie Mae and Freddie Mac.
[After the Financial Crisis: What Happened, What's Next] David Gothard

The turmoil has people worrying about the safety of their brokerage accounts, their insurance policies and even their "safe" stashes of cash - as the problems at Lehman produced losses for investors in at least one money-market mutual fund.

In the midst of the financial-industry carnage, the Dow Jones Industrial Average was down more than 8% for the week at one point midweek.

But stocks soared Thursday and Friday as the government announced a massive effort to try to keep the financial system from unraveling. Key components: a plan to help financial institutions unload toxic mortgage assets and new federal insurance for money funds.

How did all this happen and where do we go from here? We tackle those questions and others below:

Q: What's behind the financial crisis?

A: The latest woes are a continuation of the housing meltdown and the resulting "credit crisis" that have been bedeviling the U.S. Home prices have been tumbling and foreclosures soaring since the bursting of the housing bubble just over a year ago - and the effects extend throughout the economy.

Banks have taken huge write-downs on bad mortgages and become stingier with new loans. Moreover, many problem loans were sliced up and resold to investors as mortgage-backed securities and other products, producing losses for a host of banks, securities firms and insurance companies.

Other companies, including AIG, have suffered big losses on contracts they sold providing insurance against losses on mortgage-related investments.

Q: How could conditions deteriorate so quickly that companies rushed to sell themselves or couldn't survive without U.S. help?

A: Part of the problem has been a crisis of confidence. Lending markets that form the backbone of the capital markets froze up. Many financial firms had become so big and their holdings so complex that no one was sure what their exposure was to the mortgage market. In recent weeks, fear that housing-related losses would sink even large firms made it impossible for some companies to raise the cash needed to support their operations.

In recent years, many companies, like many families, loaded up on debt - which magnifies profits when times are good but also increases losses when things go sour.

Recently, giant financial firms have tried to get their houses in order by "deleveraging" - selling off assets, reducing debt and building up capital. But widespread efforts to sell distressed securities only push prices down further, leading to further write-downs that leave companies desperate for even more capital.

Q: What does this financial-industry meltdown mean for the broader economy?

A: "Companies and consumers alike are finding it more difficult to borrow," which likely will crimp business activity, says Jeff Fishman, who runs JSF Financial, a Los Angeles-based financial-advisory firm. "This could lead to an uptick in bankruptcies, which we've already seen, and the attendant job losses, cuts in consumer spending and confidence."

And remember that the recent crisis on Wall Street follows months of debate among economists on whether the U.S. economy is already in a recession or on the verge of entering one.

Q: How would the government's new plan stem the crisis?

A: The plan likely will involve spending hundreds of billions of dollars to buy distressed mortgage investments from financial institutions at deeply discounted prices. That should add a dose of confidence to frozen lending markets by assuring participants that at least one large investor - the U.S. government - stands ready to buy these assets. Congress has signaled that it is open to working with the administration; approval could come this week.

Q: Will that intervention turn things around?

A: The hope is that it will prevent the crisis from spinning out of control and will thus buoy the economy.

A revival of the credit markets and a bottoming of the housing market are keys to a revival. The government's debt plan may reduce the level of fear in the market, enabling the credit markets to operate properly. But such a plan wouldn't do anything about the excess supply of homes and the large number of mortgage borrowers in dire straits.

Q: So what's the outlook for the economy and the stock market over the next few months?

A: Housing could take many months to bottom, and then rebound, analysts say. Meanwhile, economies around the globe could weaken dramatically, something many investors aren't counting on.

Still, investors shouldn't get too gloomy.

The stock market's decline of about 20% from last fall's peak is close to the average fall for the market in periods of recession, notes Citigroup strategist Tobias Levkovich. "One can suggest that a bottom is near," he says.

Adds Peter Brodie, director of investments at a unit of Bryn Mawr Trust: "History has shown that it is crises such as these that create the extreme pessimism required to set the stage for meaningful market recoveries - and we feel that the resiliency of our economy will again be exhibited as we enter '09."

Q: Is there any other good news out there?

A: Yes. The recent collapse of energy and commodity prices will make it easier for consumers to fill up their gas tanks and heat their homes. It also will reduce pressures on many companies.

At the same time, inflation fears are subsiding, as the consumer price index fell 0.1% in August, the first monthly fall in almost two years. That all makes it virtually certain that the Federal Reserve won't raise interest rates any time soon, and might even cut them.

Moreover, hard as it is, investors should work to see the bright side of low stock prices. "Only those who will be sellers of equities in the near future should be happy at seeing stocks rise," famed investor Warren Buffett noted in 1997. "Prospective purchasers should much prefer sinking prices."

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