Monday, September 14, 2009

Financial Meltdown History

A year ago, the US investment bank, Lehman Brothers went bankrupt. After helping to bailout Bear Sterns, the mortgage giants - Freddie Mac and Fannie Mae, and other banks, the US monetary authorities felt they had to draw a line in the sand and let banks face up to the consequences of their reckless behaviour and poor decisions.

The impact of allowing Lehman Brothers (with a a balance sheet of $600bn) to go bankrupt was to create a firestorm of financial panic, which threatened to engulf the whole financial system.

Why Did Lehman's Bankruptcy Cause So Many Problems?

Lehman were involved in underwriting other bank and company loans. Many people who had been dealing with another company were taken aback to find the bankruptcy of Lehman left them out of pocket even though they had not directly dealt with them.

Until Lehman went Bankrupt, the markets implicity believed that no big bank would go bankrupt. Banks were a safe investment, because markets felt banks wouldn't go bankrupt. The failure of Lehman caused markets to re-evaluate their assessment and risk of other financial bodies. If Lehman was allowed to go bankrupt, suddenly many other banks looked very vulnerable and markets needed to reprice their evaluation of banks.

Given the market fall out from Lehman's bankruptcy, governmentw soon realised they simply couldn't afford to let other banks go bankrupt. If they did there could be an unstoppable wave of financial panic leading to a great depression like in the 1930s. Therefore, in quick succession, governments on both sides of the Atlantic were forced to intervene nationalising banks or facilitate the rescue of former banking giants.

The cost of the subsequent bailout has topped over $9,000bn. This is the scale of intervention in banks that was required to restore confidence.

The Treasury hoped letting Lehman go under would show banks they had to be responsible for their own mess. But, this proved unworkable. It merely led to a defered intervention on an unprecedented scale.

Whilst this was a necessary evil to deal with the real threat of financial and economic meltdown, it still leaves the thorny problem of making banks responsible given the implicit state intervention.

The taxpayer should be rightly annoyed at the amount of their money going to bailout banks, making sure it doesn't happen again is easier said than done. (see: problem of bank regulation)


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