Impact of the Credit Crisis on Financial Market Liquidity

Impact of the Credit Crisis on Financial Market Liquidity

Impactof the Credit Crisis on Financial Market Liquidity

Inthe mid-1800’s Henry Emanuel and Mayer Lehman moved from Germany toMontgomery in Alabama. They established a small shop that soldgroceries to local farmers. The farmers paid for groceries withcotton the brothers relied on the sale of dry cotton and driedgoods. Consequently, in 1858, the brothers managed to set up anoffice in New York. They also played a big role in the establishmentof the New York Cotton Exchange. The brothers also began trading inother commodities and helping companies raise capital through bondand equity markets. They finally became members of the New York StockExchange (Ward 26).

ByMarch 2006, the firm had outgrown its foundations. The LehmanBrothers adopted a new strategy. It involved capitalizing itsexperience on real estates. It had been successful at pursuingsimilar business in the early 1980’s. However, instead of acquiringsecurities with the aim of moving them to third parties, the newstrategy was different. The Lehman Brothers acquired real estate andkept it for its gain. It, therefore, assumed the risks and thereturns in hope of greater profits. It targeted to grow its majorareas in leveraged loans, private equity, and commercial real estate.Consequently, by mid-2007, the company had bought a significantamount of real estate. The increased supplies of mortgages led to adecline in prices. The mortgage market started heading downwards.When the mortgage market started turning sour, there was the need forincreased liquidity in forms of cash. The composition of assets heldby the Lemans made it difficult for the firm to raise cash, hedgerisks and sell the assets to reduce the debt on its balance sheet.The Lehman Brothers proceeded to file for bankruptcy on September 15,2008. It was the fourth-largest U.S investment bank and initiated thelargest bankruptcy proceeding in the history of the United States(Chapman 18).

Thebankruptcy included a declaration of USD 639 Billion in assets and613 billion in debts. The company had worldwide offices that providedemployment to over 25,000 people. The federal government did notemploy extraordinary measures to save Lehman Brothers similar to howit saved JP Morgan a few months ago. The demise of Lehmann Brotherswas due to the financial crisis in the US that began in the subprimemortgage industry in the year 2007. The financial crisis spread tothe credit markets and eventually managed to affect the financialmarkets (Buckley 102).

Thestructure of investments banks is made to enable people to borrowmoney. They create liquidity in the market. The banks business is totie up as much money as possible in long-term loans to increase itsprofits. Keeping money in the bank is not profitable however, notkeeping enough money causes trouble. The lack of liquidity makes thebank fail to pay customers that want to withdraw their money. Theproblem occurs when there are large numbers of people that want towithdraw their money. In such as situation, banks need to borrowloans from other banks or governments. Failure to obtain money makesthe bank declared bankrupt (Kolb 45).

Thefirst effect of the fall of the Lehman’s brothers is the burstingof the housing bubble. The fall in the prices of houses created amajor impact on the wealth of individuals. Besides, it affected thespending and increased the defaults that were held by financialinstitutions. The major cause of the increase in house prices was dueto increased supply of credit. Consequently, there was a lot of moneyin circulation that stimulated demand for mortgages, which furtherled to the decline of banks and pension funds perception of risk.Consequently, they supplied more money to fund loans to individualsthat needed to buy houses (Ovanhouser 33).

Theincrease in wealth further boosted the confidence in spending ongreat market players. The Federal Reserve had cut the interest ratesby 550 basis points from the year 2001 to 2004. The housing bubblewas from a group of investors that abandoned the stock markets in2001. The investors ventured into the housing market and drove up theprices. The rising demand in China and other upcoming countries alsoplayed the part in the rise in the prices (Kolb 100).

Theburst of the housing bubble occurred as a surprise fall. There wasdiminished delivery of goods and services from the housing investmentthat is large in the United States, United Kingdom, and Europe(Buckley 12).

Thesecond impact is wealth on stock prices and interest rates. Thedetermination of bankruptcy for Lehman Brothers resulted in a declinein the stock markets. Consequently, stock prices fell as indicated bythe S&ampP 500 index. In the year 2007, the index was at its peak.However, the index fell by 57% from the year 2007 to 2011 andremained 27% below its peak. A similar margin reduced the financialwealth of individuals who had invested in the stock markets. Forthose who decided to sell their stocks, they lost their incomesconsecutively (Ward 56).

Thefall in stock prices affected the wealth of retired households. Theretired households follow a strategy of spending their interest anddividends as they preserve the capital. Chances are very minimal forthe optimality of such a strategy. The lifecycle of savings behaviorprovides that households should gradually reduce their wealth afterretirement. The decision on consumption considers both the marketvalue of the financial assets and the prospective income fromdividends and interest. The effect on the wealth of retiredindividuals further affected the consumption (Chapman 18).

Thehigh prices that resulted from high inflation in the financial crisisresulted in high costs of operation for the firm. The costs entailedincreased costs of raw materials, labor, and capital. The cost ofcapital was high due to high interest rates charged by the banks.Immediately after the crisis, the Federal Reserve adopted a monetarypolicy to reduce the supply of money in the economy. The policyinvolved increases in the interest rates charged on loans by banks.The raw materials were costly due to the decreased relative value ofthe dollar to other currencies. Manufacturing firms incurred highercosts on the importation of raw materials from countries such asChina.The increase in wages and salaries resulted from the increasedprices that led to higher cost of living. Consequently, employee’sdemanded higher salaries and wages for them to match with the highcost of living (Kolb 41).

Theincrease in costs further led to a fall of the corporate profits.Consequently, the firms could not afford to maintain a constantdividend. The corporate firms that managed to pay dividends paid asmall amount based on their minute profits. The wealth of individualsthat had invested in stocks was immensely affected (Kolb 42).

Theeffect of the financial crisis on incomes was broad. First, thedecreased company profits led to employee layoffs. It affected theincome of families that heavily depended on employment income. Thesubsequent higher rate of unemployment resulted in an oversupply oflabor in the United States labor market. Consequently, the firmsreduced the pay for workers by approximately 70%. A majority of jobsheavily leaned towards low pay work and part-time jobs. A report fromthe San Francisco Federal Reserve indicated that the portion ofpart-time jobs was high. A majority of employment opportunities lostduring the recession had not been recreated. Specifically, reportsindicate that during 2000 to 2011, there was a great loss inmanufacturing jobs (Ovanhouser 33).

TheMidwest and the South encountered accelerated unemployment rates of34%. Other areas such as Michigan and Indiana recorded miniatureemployment of 19% and 12% respectively. Consequently, there werecaveats as Auto workers unions gave up their request for higher wagesand benefits. For example, new hires were allowed to work under hardconditions that included lower wages and benefits compared to thosethat had held their jobs for a longer period (Buckley 100).

Inaddition to the corporate, there was further unemployment from thegovernment sector. The government conducted greater layoff comparedto the private sector. Also, it employed significant changes in thepublic labor force. They included scaled back retirement and healthplans, salary freezes, and paid cuts. There are states that employedpay cuts, furlough days and salary freeze simultaneously.Specifically, the state and local governments shed approximately681,000 jobs. The wages from the public sector only increased by 1.1percent compared to that recorded in the private sector of 1.7%. Consequently, the unemployment benefits were reduced to levels notwitnessed ever since 1935. The unemployment from the government andthe public sector created an unemployment stampede. The stampedecreated increased demands for unemployment insurance funds. Theunemployment claims increased from a weekly average of 321,000 in2007 to 670,000 in March 2009 (Ward 26).

Thecrisis has led to reduced wealth creation by individuals due tounemployment, salary cuts and a high cost of living. Householdsreduce their expenditure on certain items such as homes. The maincause is the high uncertainty related to the mortgage market.Consequently, households prefer holding their money as opposed toinvesting. Holding money emanates from the lost trust with thefinancial markets (Buckley 102).

Second,the households lack sufficient savings for the creation of wealth.The high prices of goods and services implied high costs of living.The disposable income for households was reduced resulting in fewersavings. Whenever the households are not able to provide enoughsavings to the financial system, there is not enough money forfinancial institutions to lend. The creation of wealth gets limitedfrom various dimensions. They include investing in stock markets andthe purchase of capital assets. The wealth creation of corporationsgot curtailed too. The increased costs of production for corporateorganizations reduced their profits. Consequently, the corporatesector became deficient of enough money to invest in capital assets(Ovanhouser 56).

Thedecrease in the savings made by households created severalimplications on the ability of capital accumulation by the corporateorganization for wealth creation. First, the insufficient savings byhouseholds created a deficit of funds in the financial institutions.The deficit further caused the demand for funds to outplay the supplyof funds. Consequently, the interest that is the price for capitalincreased. The higher the interest rates, the lower the amount thatcorporate is willing to borrow for wealth creation purposes. Withoutgovernment intervention, the process can result in a vicious cycle,and the recession can last longer. The results of a prolongeddepression may be terrible (Ward 26).

Thestudent’s income reduced following a reduction in governmentspending. Specifically, the various states reduced their spending by3.8% in the year 2009. An additional reduced spending by 5.7%followed in the year 2010. The reduction in spending affectedcritical sectors such as education, transport and public assistanceprograms. In the period between the years 2008- 2013, the highereducation spending fell by more than 30%. The decline is adjusted forinflation for each college student. States such as Arizona had thegreatest reductions of 50%. The reduction was more than 20% inthirty-six states. However, two states –North Dakota and Wyoming -did not reduce their spending on Education. The decrease that hasresulted from reduced government spending causedhightuition for students (Buckley 102).

Theinvestor’s income and wealth were vastly affected. The crisisresulted into an expected decline in the short-term interest rates.Specifically, businesses and short-term interest rates for individualinvestor reduced immediately after the depression due to weakeconomic recovery. The short-term interest rates determine theincomes of investors that held short-term securities such as Treasurybonds and fixed deposits. Consequently, businesses and individualswere unwilling to take new loans as an attempt to build their wealth. The effect caused a reduction in the demand for credit (Chapman 18).

Althoughthe interest rates had consistently declined since the year 1980,they hit their lowest during the crisis. The decline in interestrates implied that bondholders lost the value held in the bonds. Theycould only sell the bonds at a loss. Besides, their income from bondinterest had reduced significantly (Kolb 84).

Interestrates affected the financial wealth of investors that had placedtheir incomes inform of fixed deposits. Specifically, there was highinflation due to the increase in prices. The incomes on savings aredependent on real interest as opposed to nominal interest. The realrate earned on savings is obtained by reducing inflation from nominalinterest. Consequently, the rapid increase in inflation implied thatthe real interests on savings were on the decline (Kolb 64).

Inconclusion, the 2007 -2009 financial crisis caused great adverseeffects. The fall of the Lehman Brothers was just a sign to indicatethe magnitude of the crisis. The individuals that had invested ininterest-based capital assets were the most affected from the fall inprices and the increase in the cost of credit. The crisis greatlyaffected people’s incomes by creating unemployment. The expensivecost of living that has resulted from inflation further resulted inthe increase in the prices of goods and services. The inflationcontributed to the increase in production costs that added tounemployment. Consequently, it had a significant effect in reducingthe wealth creation of individuals. Both the private sector and thegovernment were affected by the financial crisis.

WorksCited

Buckley,Adrian. FinancialCrisis: Causes, Context and Consequences. Harlow, England: Financial Times Prentice Hall, 2011. Print

Chapman,Peter. TheLast of the Imperious Rich: Lehman Brothers, 1844-2008.New York: Portfolio/Penguin, 2010. Print.

Henley,Patricia. TheHummingbird House.Denver: MacMurray, 1999. Print.

Kolb,Robert . TheFinancial Crisis of Our Time.New York: Oxford UP, 2011. Print. TheFinancial Crisis Inquiry Report: Final Report of the NationalCommission on the Causes of the Financial and Economic Crisis in theUnited States.New York: Public Affairs, 2011. Print.

Ovanhouser,Raymond. FinancialCrisis in America.Hauppauge : Nova Science, 2009. Print

Ward,Vicky. TheDevil`s Casino Friendship, Betrayal, and the High-stakes Games Playedinside Lehman Brothers. Hoboken: John Wiley &amp Sons, 2010. Print.