Banking And Financial Services How Reliable Is The System?

The near collapse of the banking and financial services industry in the fall of 2008 due to the systemic risk posed by such prominent companies as Bears Sterns, Lehman Brothers and American International Group (AIG) has led many to believe that the current system may be unreliable. In fact the banking and financial services is as strong today as it has been, thanks to government intervention.  The actions taken from late fall 2008 through the early spring of 2009 has moved capital into much needed places and created an impetus for changes in the way lending institutions and other financial services companies behave.

Systemic risk is the risk that the collapse of prominent financial services company will cause the collapse of the entire economic system.  Because this risk threatens our way of life, it is important to understand the lessons of the past that nearly brought us to the brink of financial calamity and take proactive measures to avoid repeating them.

Sub-Prime Mortgage Crisis
The sub-prime mortgage debacle was one of the contributing factors to the near fatal collapse of the financial markets.  A sub-prime mortgage is a form of lending given to individuals who have low credit score.  The programs were touted as second-chance lending and allowed individuals with no other recourse to become homeowners.  This homeownership however came at a heavy price.

The rates charged for these types of loans were exorbitant and well beyond what could be afforded.  They became attractive as securities instruments when bundled or packaged with other loans because of the high interest rates that these notes carried. As notes were retired within the pool of mortgages, investors were receiving better than average returns, which fueled speculation, and to some extent greed.

The problems with the products were that as loans would default, they caused entire packages to underperform and as more and more defaults occurred, more and more investors’ loss money.  Unfortunately, the largest investors were huge insurance companies and investment firms like AIG and Lehman Brothers who has no recourse but to sell at a loss or risk having worthless paper on their hands.  In the case of Lehman Brothers and Bears Stearns, this led to their collapse, while AIG essentially went into Federal receivership.

Federal Stimulus and Bailout
The use of Federal dollars to stimulate confident and growth in the economy and bailout firms that made a mistake has cause a bit of controversy.  It is one of those dual edge swords that cuts both ways.  One the one hand, the government was left with few options but to provide loan guarantees and infuse capital into them financial markets to keep them from failing.

On the other hand, many believe that the recovery process that has slowly taken place would have occurred on its own in its due course, as such cycles do.

Given that the mechanism for lending, the credit markets, had frozen up and that the loss of lending meant that employers could not meet payroll or pay suppliers, the ripple effect from the risk that the banks and other financial institutions exposed us to more than justified any stabilizing attempts to jumpstart the economy.  The price for inaction was too high a price to pay.