The recent financial crisis in the United States began in October 2008. This was a severe financial depression that caused several financial institutions to collapse. Although this financial dislocation was felt in the course of 2008, it was actually the climax of the credit crunch that began in 2006 and proceeded into 2007. This paper seeks to explore the onset of the recession in 2007 and its spill-over effects. Particularly the paper will consider the implications of the recession on AIG and Lehman Brothers. Further, in the course of the recession, the government decided to help AIG and not Lehman. It will thus be interesting to unravel the reasons behind this decision. The paper will also consider the implication of the financial recession on the banks, real-estate markets and the government’s intervention in each case.
The Beginning of the 2007 Financial Crisis
The 2007 financial crisis in the U.S. began with the decline of house prices and the consequent dramatic rise in foreclosures. This made the credit rating agencies to downgrade their assessment of risks especially for the asset-backed financial instruments in the course of 2007. The rising risks limited the ability of the issuers of financial credit services to pay interests. The U.S. housing and credit bubbles was thus faced with unforeseen losses especially for the asset-backed financial instruments.
With the financial crisis setting in swiftly in the housing sector of the U.S. economy, severe dislocation developed with risk assessment reports indicating a general downgrade trend. So drastic was the financial crisis that it soon hit the banking industry in October 2008. This industry was shaken, beginning with Lehman Brothers and the American International Group (AIG). Since these were the leading insurers of credit defaults, the banking industry and the housing sector got worst hit. The financial crunch thus set into the American economy through the housing and the banking sectors and eventually shook the entire economy with the incapacitation of the major financial institutions.
The differences between AIG and Lehman Brothers during the Financial Crisis
The 2007-2009 financial crises greatly hit the U.S. banking industry. Lehman Brothers, an investment bank filed for bankruptcy on 15 September 2008 after it failed to raise the minimum financial threshold required inform of capital to underwrite its securities that had greatly been downgraded. This move was caused by the government’s unwillingness to bailout some financial institutions, Lehman being one of them. This led to an instant spike in the interbank lending rates in the United Sates. It is however very ironical that the government adopted a selective bailout approach. The selective bailout approach left out institutions like Lehman Brothers whereas the American International Group (AIG) was rescued from the crunch. This leading financial credit insurer had suffered severe liquidity crisis after downgrading of its credit rating.
As the financial crisis continued to hit the housing security sector, the American International Group and the Lehman Brothers registered very poor performance and were at the verge of closing down especially due to the high losses the financial institutions registered as the financial meltdown continued to hit the U.S. economy. The iteration support that the government gave enabled AIG to continue operating in the financial market despite its relatively lower rating in the market.
The huge differences between Lehman and AIG made the government to come to the aid of AIG and not Lehman during the 2007-2009 financial depression. The American International Group (AIG) is the largest financial risk insurer in the U.S. financial sector. Lehman only comes fourth in terms of market share. Lehman’s network of financial operations is limited within the Wall Street. On the contrary, the reach of AIG went past Wall Street and touched on other investment areas. These include the money markets, the pension funds and other significant financial institutions in the U. S. financial markets.
Lehman as a financial player in the market was not as networked as AIG. Unlike Lehman, AIG insured everything including cars and provided the largest insurance and financial services and investment products across the globe. Therefore, the greatest difference between AIG and Lehman is in the fact that Lehman was not as broadly networked as AIG in its operation in the investment and the financial services in the United States.
Reasons why Government Intervened in AIG Case and not Lehman Brothers
The networked nature of AIG as a financial institution in the United States enhanced its chances of getting attention from the government in the wake of the financial meltdown that hit the U.S. The government responded to the financial crisis by rescuing largest financial institutions from the plunging into further losses especially taking into consideration the economic implications of the disintegration of such institutions on the real U. S. economy. The impact of an insolvent AIG on the U.S. and the global economy was considered to be potentially riskier than Lehman’s closure. Therefore, the government’s intervention to cushion AIG and not Lehman was principally because of the imminent adverse impacts its closure could have had not only on the U.S. economy but also the global economic performance.
The instrumental nature of AIG in the U.S. and the global economy made the government to offer it $ 85 billion loan as a bailout strategy against the soaring impact of the 2007-2009 financial dislocation. This explains why Lehman was left to go bankrupt while AIG got special attention. So significant was AIG in the U.S. and the world economy that it could not be ignored and left to plunge into insolvency as other financial institutions. A collapse of AIG caused by the financial crisis was a dreaded eventuality. This was not the case with Lehman’s financial insolvency. Unlike Lehman, the insolvency of AIG would imply that most of the institutional investors around the world respond by immediately writing down a lot of dollars in debt securities since they all looked up to AIG for their own securities.
Governmental Bailouts to the Major Banks and Justification for the Response
The consequences of the recent U.S. financial meltdown were so far-reaching that the government had to intervene to cushion the economy against further depression. The response involved the passage into law of a legislation that allowed the Treasury to spend up to $700 billion in the financial sector to bailout the major banks, mainstream companies like General Motors and other financial institutions. This law was passed on October 3, 2008 and is popularly known as the governmental bailout. The U.S. Secretary of Treasury was allowed to spend up to $700 billion in purchasing the assets and the mortgage-backed securities especially those held by major banks that were at the verge of shrinking.
The bailout plan that was launched by the U.S. government greatly helped in keeping the real economy from further meltdown following the financial crisis that the economy faced. The banks that were at the verge of shrinking were helped to offset millions of the losses they had registered as a result of the hitting financial crisis. Thus through this action, the Treasury was able to protect the banks from yielding chronically and fatally to the huge economic pressure that the U.S financial sector faced. The bailout targeted only the major banks, corporations and other financial institutions whose collapse would have caused huge financial loses across the globe.
The government gave the major banks and financial institutions a bailout in an approach that was very systematic and strategic. The decision to issue bailout to the major banks and financial institutions was motivated by the then urgent need to put new life into the economy and the financial services market that was struggling in the face of the financial crisis. The government was aiming at giving liquidity to bankrupt or even banks which would then be used to stabilize the lending and borrowing in the financial markets.
The move by Henry Paulson and the Federal Reserve can be interpreted to have implied a government takeover in the financial sector. It appeared like an interference with the principles of a free market economy and the promotion of the socialist economic principles in the free capitalistic U.S. market. However, in the long term, the move by the Federal Reserve is justified. The banks, corporations and other huge financial institutions could have led to greater depression of U.S. real economy if the bailout intervention was not adopted. This is because the financial institutions like American International Group (AIG) had great interconnections with all the other sectors of the U.S. and the world economy. This implies that a slump in these institutions could have shaken U.S. and the entire world’s economy.
Who Carries the Blame for Recent U.S Financial Crisis?
In many cases, speculation, overuse of credit, risky banking behaviors, and weak governmental regulation are blamed for economic and financial crises that face an economy. This was not the case with the recent U.S. financial meltdown. In this case, government barely carried the blame. The crisis actually dates back to the early 2000 when the government made deliberate effort to spur economic growth.
The Federal Reserve dropped the interest rates that it charged on the borrowing banks drastically from 6.5 to 1 percent. The banks in turn charged low interest rates on the borrowers making it easy for people to afford mortgages for housing. This raised the housing prices rapidly. However, when the Federal Reserve raised the interest rates, banks also increased the mortgage rates setting in a crisis in the housing sector as mortgages became very expensive for people to pay. The banks thus started registering losses as a result of unpaid mortgage credits. This rise in mortgage defaults was the beginning of the crisis. The government and the Federal Reserve in particular are therefore to blame for the recent U.S. financial crisis.
The decline in the real-estate that resulted from the drastic change in the mortgage rates is the root cause of the collapse in the U.S. money markets. The mortgages became generally expensive after the banks raised the interest rates in response to the high rates that were set by the Federal Reserve. The speculation in the mortgage rates and house pricings caused more havoc in the already staggering U.S. financial markets. The mortgages that could not be fully paid for by the borrowers ended up being taken over by the government after the bailout law was passed to secure the major financial institutions from the financial mayhem associated with the losses. The decline in the real-estate was therefore such a great force and significant contributor to the market collapse.
The Historical Significance of U.S. Financial Crisis
The U.S. financial crisis was very significant to the world economy. It is historically referred to as the great depression. The shake up of U.S. economy spread to the entire world. This is because of the impact the depression had on the major financial institutions. These institutions were interconnected to the economies of other countries across the globe. Thus a shake up on the U.S. economy had far-reaching consequences on the global economy. The regulatory structures and the intervention strategies that Federal Reserve put in place to protect the major banks and financial institutions from collapse and insolvency was thus a move towards the right direction in protecting the global economy against the imminent economic slump. Without the intervention to control the soaring impact of the U.S. financial crisis, the global recession could have worsened off.
The U.S. financial crunch from 2007-2009 had great implications on the U.S. economy. Although its origin is linked with the real-estate crises, the Federal Reserve was largely to blame because of its economic growth strategies that caused a fluctuation in the lending rates by financial institutions. However, the Treasury and the Federal Reserve government’s response to bailout the major banks and financial institutions fairly helped to contain the crises. Although it spread to the global economy, its impact could have been greater without the intervention that cushioned the major financial institutions from the crunch.