“The Great Recession: Where Did Our Money Go?”
Growing up in a suburb of the financial capital of the world, Ihave often heard two distinct phrases: “Money makes the world go ‘round,” and “Cash is king.” I grew up learning that money is a necessary tool for getting what you want, and that no one refuses cash as payment. Cash is so universally accepted because it is the most liquid form of currency. By definition, liquidity is “the degree to which an asset or security can be bought or sold in the market without affecting the asset's price” [Investopedia]. Liquid assets are those that can be most-easily exchanged on the market. The lack of liquidity in the 2004-2007 financial markets was directly responsible for the globalphenomenon known as the Great Recession. The specific factors that created such an illiquid environment, according to the National Bureau of Economic Research, were “an exorbitant rise in asset prices and associated boom in economic demand … a result of the extended period of easily available credit [Wearden] and inadequate regulation and oversight [Andrews].”
In every basic finance class, we learn that a firm’s capital structure is composed of two major parts: (i) its debt, and (ii) its equity. Leverage measures the proportion of debt a firm uses to finance its assets [investopedia]. Leverage is a very useful tool, as it allows any given firm to increase its investment, and therefore yield, potential.However, it is important to remember that debt, by its very nature, is risk; thus, increasing leverage directly magnifies both potential gains and losses. In 2004, Congress adopted aggressive leverage legislation, requiring commercial banks to reduce capital requirements from $1 per every $7 of lending to $1 per every $15 of lending. The SEC followed suit, reducing investment banks’ capital requirement ratios from $1 per every $15 outstanding debt to $1 per every $30 outstanding. Banks responded immediately by reducing their capital-in-hand and...
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