The Financial Meltdown of US Markets
The meltdown of the United States financial markets in 2008 was a defining moment for the future of the banking industry. At the time, it was widely believed that the value of homes would always increase. This led to many banks offering sub-prime mortgages, which allowed a high return on investment. However, these mortgages were offered to individuals who could not afford them, which resulted in many foreclosures and a huge decline in home value. One of the first large firms to face collapse due to the loss in value of sub prime mortgages was Bear Stearns. Due to the large quantity of investments held by the firm, it became a great interest for Wall Street and even the Federal Reserve Bank to make sure Bear Stearns didn’t go bankrupt.
The main concern with Bear Stearns was really more about systemic risk than it was the financial stability of the firm. Systemic risk is basically the risk of collapse of the entire financial market or system. Wall Street firms and the Federal Reserve believed that if a firm like Bear Stearns faced bankruptcy, then many other firms might follow suit, which could be detrimental to the US financial market. This could also cause Contagion, in which a decline in our asset market could cause changes in the asset prices of other markets around the world. This is a growing concern in today’s global economy. When it became clear that Bear Stearns would fail and go bankrupt, the Federal Reserve responded by providing funds to JP Morgan Chase to buy out the firm. Because of this decision, moral hazard became an issue. Moral hazard was defined by economist Paul Krugman as “any situation in which one person makes the decision about how much risk to take, while someone else bears the cost if things go badly.” Essentially it was a threat to our capitalist ways if firms came to believe they could take excessive risks and not face as great of a loss since they would be bailed...
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