At the beginning of the movie, there is a discussion about how owning a home is part of the American dream. How did the housing and mortgage markets trigger the financial crisis?
The GSEs, Freddie, and Fannie were not obliged to counterbalance the loan portfolio size with adequate capital arising from the sale of stock to envelop it. This emerged as a result of GSEs lobbying efforts as well as due to the reason that the loans were insured, thus they felt there was no need to do it. As an alternative, they utilized derivative instruments to hedge risk arising from the interest rate variations of their investment portfolios. The derivative’s value fell, followed by their capability to insure the loans.
The high exposure to the derivative instruments confirmed their downfall, the same for many banks. The housing prices reduced, even at the end of it, eligible borrowers owed more than the home value. In case they required putting up the house for sale on any ground, they would have lost less cash letting the banks foreclose. The borrowers who had a negative amortization, as well as interest-only debts, were the most affected.
In the scene when Paulson sat in the garden outside his home in the middle of the night, and when his wife sat next to him, Paulson explained to his wife that things looked pretty bad. He said something along the lines of “There isn’t a bank in the world that has enough money to pay its depositors…if people are not assured that their money is safe, they will take all their money out of the banks, and next week there will be no money in the banks, and the week after, there will be no milk in the stores.“
If people take all their money out of the banks, what is that called?
Disintermediation can take place if people decide to take all their money from the bank.
Why don’t banks have enough money to pay off their depositors?
The banks did not have enough money due to the financial crisis brought about by mortgage and housing markets. In that, the bank issued loans without looking at the creditworthiness of the borrower, and after the derivative’s value fell, this affected the borrowers as the loans valued increased more than the house value, and were unable to pay the loan resulting in less cash being held by the bank.
Explain why people would want to take their money out of the banks?
The people may want to take their money out of the banks as a way of protesting high charges from the banks and not lending money as well as a common protest to banks and firm bailouts with taxes they pay with little or no visible benefits to depositors other than the impossibility of getting the loans.
Explain how this affects the economy?
If people take all cash from the banks, this means that the company or government issuing bonds will be able to deal directly with the investors, the transaction costs will reduce, and the investors will be able to know the prices of various securities directly from the issuer as a result of superior market transparency. This leads to economic development due to the low cost of doing business, and the investors will save the extra cash not spent.
In a scene just a few minutes earlier, the CEO of GE called Hank Paulson. (Note that GE is not a bank!) In what respect was the financial crisis affecting GE to the point that the CEO felt the need to warn Hank Paulson?
The stock market was falling in value, and the bonds and stocks’ value was declining, and GE had to sell their bonds but was not able to do it, and the CEO, Jeffrey Immelt, was forced to call Hank Paulson, who took action and shorted GE options.
Based on your answer above, and given you knowledge of what GE produces, how would that have affected you and your family and why?
This would have resulted in a low supply of electrical equipment, gas, oil, and lighting, among others in the household. This is because if the company failed to sell the bonds, this means that it would have inadequate finances to finance operations.
Paulson let Lehman Brothers fail but not AIG.
What do you think is meant when they say a bank or a corporation is “too big to fail”? Explain with examples from the film.
This party line means that AIG bankruptcy created a huge systematic risk compared with Lehman bankruptcy since AIG was so big. AIG was a parent company that guaranteed the loan of unregulated subsidiary. AIG’s lion share profits and revenues and around 80% of combined assets, were focused amongst its various subsidiaries. But the subsidiaries did not create systematic risk and would have sustained operations outside bankruptcy.
Explain why, when he found out that AIG was in serious economic trouble, he had no choice but to intervene and bail out AIG. What would have happened if AIG had not been bailed out.
After findings out that AIG was in serious trouble, Paulson had no option but to bail out AIG because it would have wiped out $15,000 million of Goldman’s equity as well and cause everyone to inspect the CDOs.
If AIG was not bailed out, Goldman would have taken $15,000 million shock to its equity forcing it to face owners’ lawsuits for actions that were taken under Paulson watch. And the bankruptcy committee of AIG would also have sued Goldman for formulating fraudulent claims concerning the CDOs.
Why was AIG not just an “American” problem?
This is because AIG bankruptcy would have created systematic risk in the market. And AIG was a parent company that guaranteed the loan of unregulated subsidiary, which were widespread in the world.
The resolution of the crisis was that Congress passed and President Bush signed a bill creating TARP. You will need to refer to the section in the text in Chapter 11 on bank leverage and capital to answer this question.
How does this involve bank balance sheets?
Through TARP the bank is not allowed to recover losses previously incurred on the troubled assets, which are reported in the bank’s balance sheet.
What was the purpose of capital injections?
The purpose of TARP was to allow Treasury to buy illiquid, assets difficult-to-value from financial institutions and banks and thus improve liquidity of their assets by buying them through secondary market instrument, letting institutions stabilize their financial position and evade further losses.
At the end of the movie, Ben Bernanke asks Hank Paulson the following: “They (the banks) will lend it (capital infusions) out, won’t they?“ To which Paulson responds, “Of course they will”.
They wanted the banks to lend more in order for interest rate to reduce because higher supply of money in the market would have shifted the supply curve of the money to the right as a result of the monetary policy leading to decrease in the cost of borrowing.
- Extra credit: Explanation
- During the financial crisis the cost of borrowing increased as a result of low supply of money in the economy this was as a result of loose regulation of the GSEs and financial institutions like the banks. As a result of the use of derivative by these institutions the derivative value fell due to high demand and as a consequence the institutions were unable to insure the debt while the borrowers’ debt value increased as interest increased making it impossible for them to pay. This led to low supply of funds to the bank and many depositors opted to take their money out of the bank to other investments. All this led to the collapse of the mortgage and housing markets.
- Reaction
- After the explanation the family/friends ask why these institutions were loosely regulated and why they could not measure the creditworthiness of the borrower when lending. They were eager to know why these institutions were carrying out business the way they did leading to the credit crisis, and the impact of the government action of bailing out these institutions.
- Paulson
- They think that Paulson did the right thing to save these institutions like AIG, GE, Fannie Mae and Freddie Mac among others. But his actions, which were unethical, contributed to the financial crisis like the collusion with Goldman to create liquidity in AIG and obtain backdoor bailout. His actions of buying stocks and receiving calls privately without following set out rules and guidelines were also unethical. Generally, most of his actions were unethical.