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Home > banking > Financial Crisis Part 3 – TARP and Moral Hazard

Financial Crisis Part 3 – TARP and Moral Hazard

September 4, 2009

By September of 2008, investors had already seen some economic malaise. But the events of this month were on an entirely different scale, emphasizing the severity of the credit crisis in a way not seen since the Great Depression.

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Throughout the summer, the government-sponsored Fannie Mae and Freddie Mac had been battered by defaults on their mortgage and student loan holdpings. On Friday, September 5th, the U.S. Government announced it was completely taking over the companies. Common shareholders were wiped out. On September 10th, Lehman Brothers, a major investment bank, announced a $4.9 billion loss in the 3rd quarter due to its sub-prime mortgage holdings. Panicked investors rapidly sold their shares as CEO Dick Fuld struggled to find a buyer. But it was too late. Over the weekend, it became clear that no buyer was interested in saving Lehman Brothers from collapse. The same weekend, Insurance giant AIG announced it was taking a $40 billion loan from the U.S. Government to pay off bad debts associated with the subprime mortgage crisis.

At other major banks, executives and employees fearfully awaited the outcome. John Thain, the CEO of Merrill Lynch, realized that a collapse of Lehman Brothers, coupled with the bailout of AIG, would result in a severe crisis of confidence. Merrill Lynch was already struggling and could not afford such an event. With this in mind, Thain contacted Bank of America CEO Ken Lewis. Before the markets opened on Monday morning, Thain had brokered a sale of Merrill Lynch to Bank of America for $44 billion.

Monday, September 15th saw the first day of a selling frenzy. Investors unloaded their shares in financial institutions worldwide as Lehman Brothers filed for bankruptcy. The lack of confidence in the financial system also triggered a series of events known as “bank runs.” In a bank run, deposits are withdrawn from a bank at a rapid rate, drastically reducing its capital base. This creates further instability, resulting in additional withdrawals due to worry about the bank’s future. Eventually, this vicious cycle can lead to the rapid collapse of an entire banking system.

Bank runs are a common theme within all financial crises. The Panic of 1907, The Great Depression, and the Savings and Loans Crisis of the late 80s all saw bank runs. This crisis was no exception. Within several days of the Lehman Brothers collapse, panicked investors were rapidly withdrawing money from several weaker banks, including Wachovia and Washington Mutual. Over the next several weeks, both of these banks failed, wiping out billions in shareholder value and exacerbating the crisis of confidence.

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