This simplest explanation for this is that when the economy failed, Bear Sterns spiked the mortgage of people’s houses, which gave the company a negative name and thus led to investors ceasing loans to the firm.
In more complex terms, Bear Sterns tied itself up in numerous derivatives dealings that involved subprime-based investments. Other banks caught on to the amount of “toxic waste”, i.e. The subprime-based investments that the firm held and they stopped making short term loans that Bear Sterns desperately needed to remain liquid. As a result, Bear Sterns was forced to start selling off assets at lower prices that their true value in order to meet payments this led to its insolvency as its assets were exceeded by its liabilities.
A Credit Default Swap (also, Credit Derivative Contract) is a tool meant to transfer credit disclosure of static income products between stakeholders. In a CDS, payments are made up to the contract’s maturity date by the buyer of the Swap to its seller. In turn, the seller approves to pay off a third party debt should this party fail or default on the loan. A CDS in itself is insurance against default of payment.
CDS were not the direct cause of the demise of Bear Sterns because at the time, as a dealer in CDS, their collateral arrangements were in place and their financial books balanced. Their failure was caused by the fact that at the time, participants in the CDS market speculated that the values of the assets of the company were surpassed by its liabilities. It is rather evident that without derivatives, their liabilities and assets would have been quite changed, but these derivatives were not the proximate cause of Bear Sterns ruin.
A Federal Reserve Bank is the operating arm of the Central Bank. Their role is to carry out economic research on behalf of the Central Bank and more importantly implement the policies of the Federal Reserve Board.
The Federal Reserve Bank played the monumental role of extending a $30 billion credit line to JP Morgan in order for it to buy out Bear Sterns, just before Bear Sterns went bankrupt.
The Treasury Department is the federal arm that administers federal finances and the most crucial role of collecting revenue. It achieves this through the I.R.S. and further financing public debt through Treasury Bonds
The Treasury Department facilitated the agreement to offer the $30 billion credit line to J.P Morgan. As a result, it took hold of collateral with an estimated worth of $30 billion in mortgage related assets previously possessed by Bear Stearns.
Systemic Risk is the risk natural to the part of or the whole market. It is also denoted as market risk or un-diversifiable risk. These risks is enforced by interdependencies and inter linkages in the market, meaning if a cluster of entities or even a single entity within the market fails, there is an effect of cascading failure that can bring down the entire market or cause its bankruptcy.
Moral Hazard is the tendency of bankers to make bad loans with the expectation that the lender will bail out the distressed banks. In this case, the Federal Reserve would do the bailing out. The US treasury secretary Henry Paulson promised that bail-out of firms on Wall Street would not be done with tax-payers money. Paulson’s moral hazard aversion led to the prevention of Lehman Brothers Inc. from getting the much needed government bailout. As a result, the bank had no option, but to file for bankruptcy protection as it did not acquire the vital government guarantee in order to mitigate the exposure of the potential buyers.
The banks allowed and issued loans to these people as they expected should they fail or default on the loans, the Federal Reserve would bail them out and in the end still make profits despite incurring massive risks associated with the transactions.
In light of the financial meltdown that caused a lot of financial havoc to all stakeholders in the mortgage industry, I strongly believe there should be laws to restrict the value of houses people buy and as such limit the amount of leverage used to buy the house. This is because the amount of leverage obtained in buying the house, i.e. the method used to finance the purchase of the house, can in the long run turn into a liability that the buyer or the financier cannot be able to offset.
The problem with having such laws in the market is that they would be difficult to implement, as the above explanation would not apply to individuals in the high class of the society. Furthermore, these laws would be in contradiction to the very essentials of a free market.
The aim of the government taking control of Freddie mac and Fannie Mae was to keep the two firms from collapsing. This was because the two were mortgage giants and their failure would have resulted in the failure of the nation’s housing industry, as home loans would have been near impossible to obtain. Furthermore, the companies held large amounts in mortgages and their collapse would have meant incurring a massive systemic risk that could lead to the systems collapse.
When Lehman filed for bankruptcy, market players and stakeholders believed it would not have a huge consequence on the system. But, it turned out that Lehman Brothers Inc. was connected to many of the stakeholders in the market and it led to a huge system failure, this caused the stock to crash.
After the government realized the impact of the Lehman Brothers Inc. failure on the system, it decided to abandon the moral hazard aversion ideal. Thus, it took over AIG since it was the biggest insurance company in the world, and its demise would have led to further immense damage on the system that would have taken a long time to recover from.
Capital injection is money or finance injected into an industry in order to boost confidence in stakeholders and potential investors within the industry.
This was because the banks had run out of ways to avert the impending system failure. Any delay would have led to further damage to the market that would have difficult to recover from and led to serious economic depression.
Unwarranted risk-taking by financial institutions is as a result of ineffective, flexible and limited risk management devices, predominantly in systemically important financial institutions (SIFIs)
The role of Audit Committees within financial institutions has been under-utilized.
Independence of auditors plays a vital role in the quality of auditing.
The huge market concentration of the Big Four Auditing firms can result in a build-up risk while smaller firms hold diversity in their growth and thus hold a better chance to compete.
Audit firms play the vital role of consolidating the risk management oversight of financial institutions.
Audit Regulators can pick the following lesson from the crisis;
There is a need to consolidate the correlation between the regulatory community and the audit profession as there is the emerging issue of whether auditors ought to authenticate an increased range of data that is pertinent to the stakeholders than is currently the case.
The video makes one able to define with knowledgeable judgment the subjectivity of performing an audit to reduce the risk of material misstatement. Also due to the nature of the meltdown, one can make necessary changes like acting independently to be a better auditor. Furthermore, to become a better auditor, one must be able to read the trends and analyze the material evidence with precision. Ethics also is an important tool from this video that should be employed to help one become a great auditor.