Why Did the American Banking System Fail

Topics: Bank, Monetary policy, Central bank Pages: 7 (2394 words) Published: November 3, 2010
1. Introduction
To understand the development and the impact of the financial crisis, the following paragraph gives a general overview about the timeline of the financial crisis and the series of reactions which caused, at the end, the failure of the American banking system and led to a worldwide economic downturn with the result of the global economic crisis. The topic of this paper is the failure of the American banking system, but as the banking systems of the whole world are interdependent, the whole situation and the whole crisis has to be investigated.

2. Timeline of the economic downturn
As a result of the declining U.S. house prices in 2006 and 2007, refinancing became more difficult and as adjustable-rate mortgages began to reset at higher rates, mortgage delinquencies soared. Securities that were connected with subprime mortgages decreased heavily in their value. As a consequence, the capital of many banks declined and the U.S. government had to help out enterprises by tightening credit around the world. In Fall 2007, it became visible that the financial market could not solve the crisis by itself and that the problems and the crisis also influenced banks on the whole globe. The interbank market froze completely because of the fear of the unknown risks of other banks. Northern Rock, a British bank, had to approach the Bank of England for emergency funding due to a liquidity problem. (New York Times, 2007) In this period, central banks and governments around the world came together to cope with the current crisis and prevent further financial crisis. The subprime crisis's unique issues called for both, conventional and unconventional methods, which were employed by governments worldwide. One method was that central banks of several countries worked together to provide liquidity support to financial institutions. The reasons therefore was to reactive the interbank market. The U.S. Federal Reserve Bank started slashing the discount rate as well as the funds rate, but bad news continued. (CNN Money, 2007) On May 30, 2008, Bear Stearns was acquired by JP Morgan Chase. (J.P. Morgan, 2008) On July 11, 2008, the IndyMac Bank failed and it was the fourth largest bank failure in the history of the United States of America. (Federal Deposit Insurance Corporation, 2008) On September 15, 2008, Lehman Brothers went bankrupt due to the massive loss of most of its clients, drastic losses in its stock and devaluation of its assets by credit rating agencies. The Lehmann Brothers bankruptcy was the largest bankruptcy in the U.S. history. (The Guardian, 2008) Furthermore, the Bank of America acquired Merrill Lynch when the company was right before a bankruptcy in 2008. Also, the bail-out of Fannie Mae and Freddie Mac by the U.S. government refers to the placing into conservatorship of government sponsored enterprises Fannie Mae and Freddie Mac by the U.S. Treasury in September 2008. By October 2008, the Federal funds rate was reduced to 1 % and the discount rate was reduced to 1.75%. Central banks in England, China, Canada, Sweden, Switzerland and the European Central Bank also lowered their rate to help the world economy. But rate cuts and liquidity support in itself were not enough to stop such a extensive financial downturn. The U.S. government then came out with National Economic Stabilization Act of 2008, which included $700 billion to purchase distressed assets, especially mortgage-backed securities. Most of the governments came out with their special programs including bailout packages, government guarantees and outright nationalization. (The Washington Post, 2008)

3. Why did the American banking system fail?
After the American banking sector failed and some bank houses went bankrupt, the search for the responsible persons and institutions began. The question was if only one person or institution was responsible for the failure of the American banking system and the economic downturn, which is a result of the banking...
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