SECTION B (Case Study Question) (Total 40 marks)

Question 1 (40 marks)

The Financial Crisis: The Failure of Financial Institutions' Specialness

The financial crisis of 2008 and 2009 (FC) has likely changed the banking and investment banking industries forever. There are now no major U.S. stand-alone investment banks.Most of the so called 'Wall Street elite' are either merged, bankrupt, or in the case of Goldman Sachs and Morgan Stanley, converted to commercial bank charters. Subprime losses also devastated one of the country's largest thrift, IndyMac.This failure alone cost the FDIC between $8.5 and $9.4 billion.The crisis resulted in the forced sale or merger of other large institutions such as Wachovia, Countrywide and Merrill Lynch and a bailout of Citigroup.Vaunted and time-tested firms such as Bear Stearns and Lehman Brothers lost all of their value due to excessive leverage and overconcentration in mortgage-backed investments.Both are now gone.As problems in the major financial institutions began spreading other markets were affected. The commercial paper market shut down until the Fed intervened and money market mutual funds potentially faced runs when one fund 'broke the buck' due to its holdings of Lehman investments. The country's largest insurer, AIG, was saved from bankruptcy only by government intervention, and even the 'Big Three' U.S. automakers faced insolvency with GM and Chrysler receiving bailouts.U.S. unemployment peaked at over 10% and the effects of the recession were felt worldwide.

Countries that did not have housing booms and had more conservative banking systems fared better during the crisis and recovered more quickly.Canada is a good example as are France and Germany. China was affected by the crisis but recovered quickly as the Chinese government quickly acted to stimulate its economy.

Therefore, the government actions to stem the financial crisis is important.A brief outline of some of the major government financial activities in US are as follows:

Troubled Asset Relief Program (TARP), up to $700 billion approved

• Capital injections to troubled institutions (in exchange for preferred stock)
• Purchase of poor-quality loans and securities
• Reducing preventable foreclosures

Funding for certain key markets

• The Fed has greatly expanded its discount window lending facility to include non-banks and to include much poorer collateral, lowered interest rates and began 'quantitative easing.'
• The Fed purchased commercial paper from high quality issuers for a time to offset a lack of investors.Heavy mutual fund withdrawals limited the supply of funds available to commercial paper markets during the crisis.Fed purchases of paper allowed refunding to continue.
• The Treasury and the Fed operated the Term Asset Backed Securities Lending Facility to encourage securitization of loans.

Expanded Federal Deposit Insurance Corporation (FDIC) backing

• The FDIC first increased deposit insurance to $250,000 per account permanently and temporarily increased insurance to 100% of the deposit amount (originally until Dec 31, 2009, extended to June 30, 2010, the Dodd-Frank bill extended this again until Dec 31, 2012).Currently the insurance limit is $250,000, but it is not clear whether the government would force losses on uninsured amounts in the event of a large bank failure.
• The FDIC fully backed any newly issued senior unsecured debt that was sold before June 30, 2009 for banks and bank holding companies.

The government also passed the controversial $789 billion stimulus package.

Adapted from Saunders, A. and M. Cornett (2018), Financial Markets and Institutions, 7th edition, McGraw Hill.

REQUIRED:

(a)Discuss whether it is important for the government to step in to stop the financial crisis.Why?(10 marks)

(b)Comments the adequacy of the government actions of US to rescue the financial crisis of 2008.Recommend two suggestions to enhance the US government actions. (10 marks)

(c)Explain the role of financial institutions in the financial system of an economy.(10 marks)

(d)Discuss three factors to explain why financial institutions still exist even though the economy has financial markets. (10 marks)