We write custom essays and can help you with

The essay examples we publish have been submitted to us by students. The essays are the student's work and are not examples of our expert essay writers' work. READ MORE


See how we can help

We write essays!

Effect of the crisis

In today environment, many studies have been conducted in order to explain the incredible effect of the crisis, but concerning investment bank's sources, it was more complex to find relevant studies. There is any study, article or books which explain openly the impact of the crisis on the investment bank. That is why we will try to explain it by developing in a first section, different literatures about the sequence of the crisis and the efficiency of the bank during this crisis, in a second section, different literature which will explain the function of investment banks in this crisis and a final section which will state different literature about debt's affecting investment banks because of crisis.

1) Crisis context and bank efficiency.

A. The Crisis

We set generally the beginning of the "subprime mortgage crisis" in August, 2007 in the United States. Let us return quickly on the origins of this crisis. The book written by Robert J.Shiller (2008) is a very relevant starting literature in order to understand this crisis. In his book, he states the origins of this crisis and suggests some measurement to solve it. It's also very useful to understand how we got into this crisis and how we can get out from it.

Subprime are mortgages with an important risk. These credits born in a very particular context: several years ago, the world economy enjoyed a numerous savings resulting from the strong rise of the commercial surpluses of China, and from petroleum exporting countries.

At the same time, the Federal Reserve has conducted a monetary policy in favor of a growth with very low interest rate. Result: a lush of liquidity which conduct investors then to bet on real estate.

According to the calculation of the economist Robert J. Shiller (2008) "the real price - except inflation-of housing in the United States increased by 85 % between 1997 and 2006 ".

During this period, the real estate brokers shut their customers towards banks. These bank allocate mortgages to households with very modest and little reliable incomes, which are attracted by very low interest rates and repayment. Robet J.Shiller (2008) describes it as low at the beginning but brutally important then. Indeed, "subprime" loans were often with low and fixed interest rates during the first two years, and changed slightly in the market rates during the rest of the period of loan, which could be the cause of difficulties in repayments for low-income borrowers. It was in fact an implicit bet on a continuous and strong increase of the real estate. As long as the real estate market rose, a household in trouble had the possibility of reselling its apartment or its house to pay off its debts in case of problem.

How, from these risky mortgages we reached at a world banking and financial crisis?

This question was adequately answered by George Cooper (2008) which in his book describes the evolution of the monetary system by explaining how instabilities emerged. First of all, as we said it, these real estate loans were permitted with the underlying hypothesis which the market of the real estate will continue to grow, but it was not the case. From the end of 2006, the American's real estate market shows signs of slack: the prices move back by 4 %. George Cooper (2008) explains that, these low-income households saddle with financial commitment, too important for them, and with real estate which depreciate. They cannot face any more their commitments and the number of non-payments which, on subprime, turned around 10 % quickly rise to 15 % of the total credit accorded. According to George Cooper (2008) the property seizure's multiply too, increasing by 60 % between January and July, 2007. To deal with that, Robert J.Shiller(2008) purposed the need of bailouts, in short run, target specially to low income victims.

However George Cooper (2008) said that it should have been only an American real estate crisis. The world financial system would have been able to absorb without any trouble a crisis limited to these loans but apparently wasn't the case.

Which made the difference in this crisis is a financial technique: the securitization. This practice consists to transform any assets, as a real estate loan, into a financial equity. Indeed, commercial banks, knowing that these credits were risked, leaned on the securitization to resell them to the others, after taken commissions. Let us be more interested in detail in this practice.

B. The securitization

The securitization is a financial technique which transforms little liquid assets, for which there is no a special market, in easily negotiable securities, as bond. Every investor acquires a fraction of new assets portfolio, on the basis of future financial flows of assets, which guarantee the repayment of the obligations. (Kendell 1996). It is also defines by Donaldson (2004) as a practice of selling and structuring debatable investments, with the purpose of spreading the risk faced by a lender to a group of investors.

Born in United States in the 70s, this technique was used at first by banks to allow more credits. Later, as we saw it, it permitted banks to get partially rid of bad risks. Indeed, in the United States as in Europe, banks can grant credits only in a certain proportion of their own resources. To distribute more credits, American banks thus began to right debt, not always the best, in order to "take off of the balance sheet", which gave back them possibilities of consent new credit lines. As time goes by, the technique became more sophisticated, an entities that we call "Special Purpose Vehicle or Company"(SPV or SPC) intervened between the bank and the investor who buys these debts. Furthermore, the various debts were "mixed" in securities with better quality and serving as reserve in case of failure. So many assets can be securitized. In international market, there is a real distinction between "asset-backed securities" (where securities are backed by other asset except residential mortgages) and "mortgage-based securities" where the asset consists of a residential mortgage (Thomson, 1955).

This technique became more developed from 2000. For example, in 2006, the global amount of the issued of securitization in Europe was 452 billion euro, against 78 billion in 2000. The American issues represented approximately two times more. (George Cooper, 2008)

In order to a better understanding of this process lets us study an example of a bank, the assignor, who wishes to close a financing based on a mortgage portfolio:

Economically, for the bank, everything takes place as if it had obtained the financing directly. Legally, there is no relationship between the investor and the bank, because the SPC is interposed between both.

Let's go back to George Cooper's (2008) explications for the crisis. In fact, when the crisis blows up in August, 2007, all the financial actors whom we evoked, took several months for realizing how much they are connected by a "ball of risks impossible to disentangle ". They begin then to become nervous. Banks, not knowing the situation of the other banks, became reluctant to lend between them. George Cooper (2008) suggests several dimensions for this crisis

Indeed, the international banking system works thanks to the interbank market (bank lends money between themselves in a day to day basis) but in panic period, there is a lack of confidence between banks, so they refuse to lend anymore. Since the beginning of the crisis, the interbank market was stopped repeatedly. Every time, the central banks restarted it by playing the role of "lender as a last resort ". They lend some money to the banks, which is pay off in a few days or weeks later. In exchange, banks give some securities to the central banks.

So they are so looking for selling their securities, which conducts to a stronger decline of their value and losses of capital.

George Cooper (2008) claims that some central banks are neglected their core role of controlling the financial system and, to contrast by pursuing their policies, they promoted a series of more violent bankruptcy. Bus as we describe above by the securitization concept, banks are not the only players in this crisis.

Let us now in a second section be more interested in the role played by investment bank in this financial crisis.

2) Role played by investment bank during the crisis

A. Role in the securitization process

By getting more and more into debt, involving their equity capital, to acquire risky financial assets or by reselling to investors assets with important consequences, investment banks took more risks from years to years. But as long as these activities were profitable, nobody questioned them. Nevertheless we know all that profitability and risks are connected (Alan Morrison et al. (2007). In spite of the implementation of the agreements of Basel, to limit their risk-takings according to their level of equity capital, investment banks were able to elude regulations thanks to financial innovations such as the securitization. The mechanism of securitization allows them to sell some "illiquid" debts, and thus to reduce their balance sheet. Alan Morrison, et al. (2007) develops in his book the concept of investment banking, its policies and institutions. According to him, investment bank bought the real estate securities emitted by the commercial banks. To get the maximum profit, they placed them in the famous SPV, Special Purpose Vehicle: ad hoc not regulated companies. These are solicited then, as we saw it, financial investors by proposing them bonds from which the repayment was guaranteed by their real estate credit portfolio. It creates an opaque environment of distribution of risk in finance. Who detained which risks? We still don't know exactly.

So investment banks played an important role in this mechanism of securitization which is the cause of the transformation from a real estate crisis to a world financial crisis.

B. Role in rescues plan.

However, they knew also how to take advantage of this crisis. The article written by Hans-Werner Sinn (2008) explains clearly right sides of this crisis for investment banks. He shows how they were repeatedly "called to rescue" by governments or banks bosses, to work on rescue plans. The investment bankers from Goldman Sachs so advised British Treasury for the nationalization of Northern Rock (they earned £100 million of banking commission), and Kuwait Investment Authority (a sovereign fund) for its acquisition of holdings in Merill Lynch. The merger-acquisition teams of Morgan Stanley's managed the bailing out of Fanny Mae and Freddie Mac, helped AIG, Bradford and Bingley, while closing the merger of HBOS-Lloyds. Merill Lynch also advised France about Dexia in binomial with BNP Paribas.( Hans-Werner Sinn (2008))

We attend a paradoxical situation: banks help governments to save banks. According to Hans-Wemer Sinn (2008)the recent storm demonstrated simultaneously the vulnerability of investment banks and, at the same time, the crucial role which they play to help public authorities to take out the credit institutions of the rut.

In fact, States have not necessarily the sufficient know-how to manage this kind of crisis and restructuring the banking and financial sector. In the urgency, they prefer to give up this kind of explosive business to investment bankers, by fixing simply a political frame and ranges of risks.

We understand it; the bigger investment banks took advantages in spite of the crisis and offered their services for attractive payments. Since almost ten years we were able to observe a real increase in the trading activities of investment banks and particularly for their account. These activities were extremely profitable these last years.

3) Concequences of the crisis in investment banks.

Before evoking the exact figures which knew the sector, let us return on some elements which amplified the consequences of this crisis on investment banks.

  1. A. Glass- Steagall Act

    2. Although the oldest investment banks were born almost two hundred years ago, the real distinction with the other kinds of banks took place at the beginning of the 20th century. (John F. Marshall 1994) Indeed, it is in 1929 that the crisis really starts in the United States, when the government asked to the banks to choose between loans and deposits activities and financial markets activities. So the position of investment banks was defines by a banking law: Banking Act of 1933, more known as "Glass-Steagall Act". According to John F. Marshall (1994 p-4) "The Glass-Steagall Act was intended as remedial legislation to separate commercial banking activities from investment banking activities". This act was considered to restore confidence in the financial system which had suffered cataclysmic damage in the wake of the 1929 stock market crash and the banking crisis and depression that followed. For John F. Marshall (1994) this law aimed at forbidding the repetition of what was perceived as one of the causes of the stock-exchange bubble and the speculation of the shares by commercial bank, as well as to protect depositors' savings.

    It is necessary to know that this measure was gradually given up after the deregulation of the American financial markets, to disappear finally definitively in autumn, 1999. Even if this separation is not compulsory today, it also stayed in practice and is at the origin important difficulties that some of American investment banks knew or know. The end of this regulation allowed the constitution of a big bank like Citigroup in the United States.

    What are the consequences of this law on today's crisis?

    . This law was also discussed by William Bernstein (2002 p-161) "The Glass-Steagall Act separated commercial and investment banking. This last statute has recently been repealed. Sooner or later, we will likely painfully relearn the reasons for its passage almost seven decades ago".

    Indeed, investments bank depend to the financial market for the refinancing, or they borrow from others same type institutions. Whereas commercial banks can also converts private individual's deposits into credits. The problem was developed by William Kaufman (2008) which qualifies this law as "bipartisan" of this crisis. So the problem is that financial institution beside of which investments banks borrows refuses today to lend this money. They prefer to keep it for them, or do not trust any more in the capacity of refund of these banks. In the Unites States, banks have to register their assets on their market value (principle of "fair value"). The market value falling, the balance sheet degrades, thus rating agencies drop "ratings".

  2. B. Short sale.

    3. There is also another problem which is developed by Bill Saporito( 2008) :short sale (sell a securities that we don't have in order to buy it at a lower rate). Indeed this technique increased the negative impacts of the crisis on investment bank. Hedge fund, for example, in their investment policy, bets on the earnings as well as on the losses of the target companies. That means that they are used to short sales. By the combination of broadcasting of rumors and short sales, the market value of a big bank can be reduced. Many of big investment banks, which knew recently difficulties, were victims of short sales. The monitoring authority learnt that the collapse of Bear Stearns, in March, was due to short sales and to the broadcasting of false rumors. Measures were then taken from August by the authorities, in the Unites States but also in Europe, to forbid the short sale on certain values.

    Hedge funds, already weakened by this short sale, began to close their accounts in "prime brokerage" departments of investments bank. Indeed, as a private individual has a deposit account in his bank, a hedge fund has in "conservation", securities account in investment banks. And in the same way of traditional banks promote private individual's money, investment banks promote securities. If the hedge fund removes its securities account, the investment bank has not guarantee anymore for its loan so it has to find another one in order to reassure its creditor. Or today these are fear of losing their money in case of bankruptcy of the bank which holds their securities account. So they removed their money from the most "risky" bank to transfer it in other bank like JP Morgan, UBS... With fewer chances to go bankrupt (Bill Saporito 2008) So this phenomenon worsens the situation of investment banks.

  3. C. Debt affecting investment bank.

    4. All these factors added to the world financial crisis which we know today, had devastating effects on investment bank.

    In terms of figures, today, the losses are more than 500 billion dollars, and it is not finished yet. We can note that 40 % of the losses concern five banks: Wacovia, Citigroup, Merill Lynch, Washington Mutual and UBS (Financial Times September 20, 2009).

    These important losses naturally had heavy consequences on the big banks, in particular American banks. Let us return more in detail on the most memorable cases of these last month's summarized in the article written by Eileen Aj Connelly (2009)

    The important restructurings begin in spring, 2008, when the Federal Reserve organizes the rescue of Bear Stearns, who is partially absorbed by JP Morgan. In March, the share price of Bear Stearns was $150; JP Morgan acquires them for $2. The Federal Reserve gets back assets at risk for 30 billion dollars. Bear Stearns is the first of "Big Five" of Wall Street to be victim of this crisis.

    In mid-September 2008, the confidence of the investors in the capacity of survival of investment banks falls brutally. These are widely involved in the bets on the financial securities connected to risky mortgage loans, their perspectives of incomes thus seem lower than the losses which they record because of the decline of the value of these securities. As nobody wants to bring them capital, their future is compromised.

    During the weekend of September 13-14th, the decision is begun to sell Merill Lynch to Bank of America, and to not help Lehman Brothers. The bankruptcy of Lehman represents for many a real historic event. The State "drops" a big investment bank. From this time, we say to ourselves that everything is possible, and the panic takes hold of the markets. Stock exchanges open the week in free-fall. AIG is nationalized. In the middle of week, the panic is total, the stock prices of investment banks collapse. The market indicates that establishments which exist for several centuries, which show a brand and know-how, are worth nothing more now. We really pass from a crisis of liquidity to a systematic crisis.

    After Merill Lynch and Lehman Brothers, two other independent investment banks, which means not supported by a commercial bank, Morgan Stanley and Goldman Sachs are affected and their stock price falls. Banks do not want to lend any more of money between them. Federal Reserve and other central banks put then several hundred billion dollars in the market.

    On Sundays evenings, we learn that Morgan Stanley and Goldman Sachs change their status. The last two big American investment banks become now simple banking companies, they add to their activities of investment banking those, more reassuring in the current context, activities of commercial bank. This change of structure allows them to have access to the discount counter of the Federal Reserve. In theory investment banks are not within the competence of the Federal Reserve, and thus cannot obtain emergency loan. These rules were however changed at the beginning of the year (2009), but only till January. In exchange for these greater opportunities, Morgan Stanley and Goldman Sachs will have to submit itself to new rules and to more authority's control.

    As underlined the Wall Street Journal (28/09/2008), "in a single week, the era of the independent investment bank has ended. Wall Street as we've known it for decades has ceased to exist Six months ago there were five major investment banks. Two -- Lehman Brothers and Bear Stearns -- have failed, Merrill Lynch is selling itself to Bank of America, and now the last two are becoming commercial banks".

    To conclude, we can summarize four ways to proceed against a bank in big difficulty:

    • No intervention, thus the bankruptcy ( Lehman Brothers)
    • We let make the market and the private investors buy back between themselves(Merill Lynch of America)
    • We nationalize (Fannie Mae, Freddy Mac, AIG). Either the establishment becomes public, or its division and its sale to the other private actors are organized.
    • Last solution: a collective solution, a rescue plan (ex: plan Paulson in the United States, European plans)

    So, since summer, 2007, the landscape of investment banks is modifying from day to day. Investment banks are responsible but also of big victims of this financial crisis. And the effects of this one were felt very quickly. In order to studying the endogenous effects and the exogenous effects, it is advisable to study the debts figures of some of investment banks. More explanation about this debts figure are provided in the next part.

    Need an essay? You can buy essay help from us today!



    Custom essay QUOTE
    ORDER a custom essay




    Request the removal of this essay.

Find out how UKEssays.com can help you with your Essays

Get help with your essay

Sign up and be the first to receive our latest offers: