Impact of the Credit Crisis on Financial Market Liquidity (Essay Sample)

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Impact of the Credit Crisis on Financial Market Liquidity
In the mid-1800’s Henry Emanuel and Mayer Lehman moved from Germany to Montgomery in Alabama. They established a small shop that sold groceries to local farmers. The farmers paid for groceries with cotton; the brothers relied on the sale of dry cotton and dried goods. Consequently, in 1858, the brothers managed to set up an office in New York. They also played a big role in the establishment of the New York Cotton Exchange. The brothers also began trading in other commodities and helping companies raise capital through bond and equity markets. They finally became members of the New York Stock Exchange (Ward 26).
By March 2006, the firm had outgrown its foundations. The Lehman Brothers adopted a new strategy. It involved capitalizing its experience on real estates. It had been successful at pursuing similar business in the early 1980’s. However, instead of acquiring securities with the aim of moving them to third parties, the new strategy was different. The Lehman Brothers acquired real estate and kept it for its gain. It, therefore, assumed the risks and the returns in hope of greater profits. It targeted to grow its major areas in leveraged loans, private equity, and commercial real estate. Consequently, by mid-2007, the company had bought a significant amount of real estate. The increased supplies of mortgages led to a decline in prices. The mortgage market started heading downwards. When the mortgage market started turning sour, there was the need for increased liquidity in forms of cash. The composition of assets held by the Lemans made it difficult for the firm to raise cash, hedge risks 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 the largest bankruptcy proceeding in the history of the United States (Chapman 18).
The bankruptcy included a declaration of USD 639 Billion in assets and 613 billion in debts. The company had worldwide offices that provided employment to over 25,000 people. The federal government did not employ extraordinary measures to save Lehman Brothers similar to how it saved JP Morgan a few months ago. The demise of Lehmann Brothers was due to the financial crisis in the US that began in the subprime mortgage industry in the year 2007. The financial crisis spread to the credit markets and eventually managed to affect the financial markets (Buckley 102).
The structure of investments banks is made to enable people to borrow money. They create liquidity in the market. The banks business is to tie up as much money as possible in long-term loans to increase its profits. Keeping money in the bank is not profitable; however, not keeping enough money causes trouble. The lack of liquidity makes the bank fail to pay customers that want to withdraw their money. The problem occurs when there are large numbers of people that want to withdraw their money. In such as situation, banks need to borrow loans from other banks or governments. Failure to obtain money makes the bank declared bankrupt (Kolb 45).
The first effect of the fall of the Lehman’s brothers is the bursting of the housing bubble. The fall in the prices of houses created a major impact on the wealth of individuals. Besides, it affected the spending and increased the defaults that were held by financial institutions. The major cause of the increase in house prices was due to increased supply of credit. Consequently, there was a lot of money in circulation that stimulated demand for mortgages, which further led to the decline of banks and pension funds perception of risk. Consequently, they supplied more money to fund loans to individuals that needed to buy houses (Ovanhouser 33).
The increase in wealth further boosted the confidence in spending on great market players. The Federal Reserve had cut the interest rates by 550 basis points from the year 2001 to 2004. The housing bubble was from a group of investors that abandoned the stock markets in 2001. The investors ventured into the housing market and drove up the prices. The rising demand in China and other upcoming countries also played the part in the rise in the prices (Kolb 100).
The burst of the housing bubble occurred as a surprise fall. There was diminished delivery of goods and services from the housing investment that is large in the United States, United Kingdom, and Europe (Buckley 12).
The second impact is wealth on stock prices and interest rates. The determination of bankruptcy for Lehman Brothers resulted in a decline in the stock markets. Consequently, stock prices fell as indicated by the S&P 500 index. In the year 2007, the index was at its peak. However, the index fell by 57% from the year 2007 to 2011 and remained 27% below its peak. A similar margin reduced the financial wealth of individuals who had invested in the stock markets. For those who decided to sell their stocks, they lost their incomes consecutively (Ward 56).
The fall in stock prices affected the wealth of retired households. The retired households follow a strategy of spending their interest and dividends as they preserve the capital. Chances are very minimal for the optimality of such a strategy. The lifecycle of savings behavior provides that households should gradually reduce their wealth after retirement. The decision on consumption considers both the market value of the financial assets and the prospective income from dividends and interest. The effect on the wealth of retired individuals further affected the consumption (Chapman 18).
The high prices that resulted from high inflation in the financial crisis resulted in high costs of operation for the firm. The costs entailed increased costs of raw materials, labor, and capital. The cost of capital was high due to high interest rates charged by the banks. Immediately after the crisis, the Federal Reserve adopted a monetary policy to reduce the supply of money in the economy. The policy involved increases in the interest rates charged on loans by banks. The raw materials were costly due to the decreased relative value of the dollar to other currencies. Manufacturing firms incurred higher costs on the importation of raw materials from countries such as China.The increase in wages and salaries resulted from the increased prices that led to higher cost of living. Consequently, employee’s demanded higher salaries and wages for them to match with the high cost of living (Kolb 41).
The increase in costs further led to a fall of the corporate profits. Consequently, the firms could not afford to maintain a constant dividend. The corporate firms that managed to pay dividends paid a small amount based on their minute profits. The wealth of individuals that had invested in stocks was immensely affected (Kolb 42).
The effect of the financial crisis on incomes was broad. First, the decreased company profits led to employee layoffs. It affected the income of families that heavily depended on employment income. The subsequent higher rate of unemployment resulted in an oversupply of labor in the United States labor market. Consequently, the firms reduced the pay for workers by approximately 70%. A majority of jobs heavily leaned towards low pay work and part-time jobs. A report from the San Francisco Federal Reserve indicated that the portion of part-time jobs was high. A majority of employment opportunities lost during the recession had not been recreated. Specifically, reports indicate that during 2000 to 2011, there was a great loss in manufacturing jobs (Ovanhouser 33).
The Midwest and the South encountered accelerated unemployment rates of 34%. Other areas such as Michigan and Indiana recorded miniature employment of 19% and 12% respectively. Consequently, there were caveats as Auto workers unions gave up their request for higher wages and benefits. For example, new hires were allowed to work under hard conditions that included lower wages and benefits compared to those that had held their jobs for a longer period (Buckley 100).
In addition to the corporate, there was further unemployment from the government sector. The government conducted greater layoff compared to the private sector. Also, it employed significant changes in the public labor force. They included scaled back retirement and health plans, salary freezes, and paid cuts. There are states that employed pay cuts, furlough days and salary freeze simultaneously. Specifically, the state and local governments shed approximately 681,000 jobs. The wages from the public sector only increased by 1.1 percent compared to that recorded in the private sector of 1.7%. Consequently, the unemployment benefits were reduced to levels not witnessed ever since 1935. The unemployment from the government and the public sector created an unemployment stampede. The stampede created increased demands for unemployment insurance funds. The unemployment claims increased from a weekly average of 321,000 in 2007 to 670,000 in March 2009 (Ward 26).
The crisis has led to reduced wealth creation by individuals due to unemployment, salary cuts and a high cost of living. Households reduce their expenditure on certain items such as homes. The main cause is the high uncertainty related to the mortgage market. Consequently, households prefer holding their money as opposed to investing. Holding money emanates from the lost trust with the financial 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 fewer savings. Whenever the households are not able to provide enough savings to the financial system, there is not enough money for...