2. Participants
Ali Akbar
Rida Ameen
The Islamia University Bahawalpur
BS Economics & Finance
Semester 7th
3. Financial Crisis
A situation in which the value of financial institutions
or assets drops rapidly. A financial crisis is often
associated with a panic or a run on the banks, in which
investors sell off assets or withdraw money from
savings accounts with the expectation that the value of
those assets will drop if they remain at a financial
institution.
If left unchecked, the crisis can cause the economy to
go into a recession or depression.
4. Global Financial Crisis
(GFC)
In the last five years or so the world has experienced what
many like to call the ‘worst financial crisis since the great
depression’. Although this crisis started in earnest in 2007,
experts say that that the setting for a crisis began about a
decade before, and that the signs were there all along.
The credit crunch
The global financial crisis (GFC) or global economic crisis
is commonly believed to have begun in July 2007 with the
credit crunch, when a loss of confidence by US investors in
the value of sub-prime mortgages caused a liquidity crisis.
5. Causes of the financial crisis
Skeptics of capitalism have also taken the time to claim
that this crisis underscores the notion that capitalism was
in fact a disaster from the word go, and that it was only a
matter of time before this would be realized.
Capitalism is an economic and political system in which a
country's trade and industry are controlled by private
owners for profit, rather than by the state.
OR A system of economics based on the private ownership
of capital and production inputs, and on the production of
goods and services for profit.
The current crisis has been characterized by a threat of
collapse of financial institutions, with governments
moving in to provide bailouts to help these institutions
survive.
6. The sub-prime crisis and housing bubble
Subprime mortgages are a financial instrument designed to
facilitate home ownership for low and modest income
households. Most subprime mortgages are adjustable-rate
mortgages and are refinanced relatively frequently. Mortgage
banks raise funds for making subprime loans mainly by
securitization. Once subprime mortgage loans are originated,
they are pooled and packaged into a variety of mortgage-backed
securities and sold to various institutional investors in the
United States and abroad.
Subprime mortgages worked as designed while house prices were
rising during 1996-2005. But as U.S. interest rates began to rise in
early 2004 due to the tightening monetary policy of the Federal
Reserve, house prices stopped rising and began to decline in
2006. Subsequently, subprime borrowers started to default,
spreading risk among investors and eroding the bank capital
base in the United States and abroad.
7. The collapse of Lehman Brothers
The fall of Lehman Brothers on September 14, 2008
marked the beginning of a new phase in the global
financial crisis.
Lehman Brothers was a key player in the United States
real estate businesses. From 2004 to 2006, Lehman
Brothers experienced a 56 percent surge in revenues
from housing business. So the sub-prime crisis put the
Lehman Brothers to death, when investors demanded
withdrawal of their investments.
Lehman Brothers crashed, suffering mainly from
liquidity problem for its heavier investment in
mortgage-based securities that are least liquidate &
highly risky.
8. Consequences of GFC
Many stock exchange markets have suffered too, as some
have been on the brink of total collapse due to huge losses
and rapidly decreasing values of institutions and stocks.
The housing industry, for example, has suffered a great
deal, both in the United States and in other parts of the
world. Home values have dropped at unprecedented rates,
leading to foreclosures and evictions.
The level of unemployment has been on the rise
throughout that period, effectively rendering a large part of
the world population poor, and reducing consumer wealth.
9. Overcoming GFC
Facing the severe credit crunch and economic downturn,
the U.S. government took forceful actions to save the
banking system and stimulate the economy.
The Bush administration-implemented Troubled Asset
Relief Program (TARP) was enacted in October 2008.
Seven hundred billion dollars of the TARP fund was
injected into the financial system to buy nonperforming
assets and mortgage-related securities from banks and also
to directly strengthen banks' capital reserves.
The Obama administration, in turn, implemented an $850
billion economic stimulus program to boost economic
activities and create jobs.
10. Many governments around the world, notably the U.K.,
France, Germany, China, and Korea, implemented similar
stimulating measures.
In addition, to prevent future financial crises and costly
bailouts, the U.S. government adopted much tighter rules
of finance in July 2010.
The new rules prohibit banks from making risky
investments with their own money, which may endanger
the core capital of banks.
Consumer Financial Protection Bureau would be set up
to protect consumers from predatory lending.
Financial Stability Oversight Council of regulators
chaired by the Treasury secretary would be responsible for
carefully monitoring the systemic risk.
11. Enron
Wall Street Darling
Enron was an American energy, commodities, and
services company based in Houston, Texas. Before its
bankruptcy on December 2, 2001, Enron employed
approximately 20,000 staff and was one of the world's
major electricity, natural gas, communications, and
pulp and paper companies, with claimed revenues of
nearly $111 billion during 2000. Fortune named Enron
"America's Most Innovative Company" for six
consecutive years.
12. Collapse of a Wall Street Darling
By the fall of 2000, Enron was starting to crumble
under its own weight.
CEO Jeffrey Skilling had a way of hiding the financial
losses of the trading business and other operations of
the company; it was called mark-to-market
accounting.
This is used in the trading of securities, when you
determine what the actual value of the security is at
the moment. This can work well for securities, but it
can be disastrous for other businesses.
13. In Enron's case, the company would build an asset,
such as a power plant, and immediately claim the
projected profit on its books, even though it hadn't
made one dime from it. If the revenue from the power
plant was less than the projected amount, instead of
taking the loss, the company would then transfer these
assets to an off-the-books corporation, where the loss
would go unreported.
Such type of accounting created the attitude that the
company did not need profits, and that, by using the
mark-to-market method, Enron could basically write
off any loss without hurting the company's bottom
line.
14. Fraud: What Was the Scheme?
The mark-to-market practice led to schemes that were designed to hide
the losses and make the company appear to be more profitable than it
really was.
In order to cope with the mounting losses, Andrew Fastow, a rising star
who was promoted to CFO in 1998, came up with a devious plan to
make the company appear to be in great shape, despite the fact that
many of its subsidiaries were losing money. That scheme was achieved
through the use of special purpose entities (SPE).
An SPE could be used to hide any assets that were losing money or
business ventures that had gone under; this would keep the failed
assets off of the company's books. In return, the company would issue
to the investors of the SPE, shares of Enron's common stock, to
compensate them for the losses.
This game couldn't go on forever, however, and by April 2001, many
analysts started to question the transparency of Enron's earnings.
15. The Shock Felt Around Wall Street
By the summer of 2001, Enron was in a free fall.
CEO Ken Lay had retired in February, turning over the
position to Skilling, and that August, Jeff Skilling
resigned as CEO for "personal reasons."
By Oct.16, the company reported its first quarterly loss
and closed its "Raptor" SPE, so that it would not have
to distribute 58 million shares of stock, which would
further reduce earnings.
This action caught the attention of the SEC.
16. A few days later, Enron changed pension plan
administrators, basically forbidding employees from
selling their shares, for at least 30 days.
Shortly after, the SEC announced it was investigating
Enron and the SPEs created by Fastow. Fastow was
fired from the company that day.
In addition, the company restated earnings going
back to 1997. Enron had losses of $591 million and had
$628 million in debt, by the end of 2000.
The final blow was dealt when Dynegy (NYSE:DYN), a
company that had previously announced would merge
with the Enron, backed out of its offer on Nov. 28. By
Dec. 2, 2001, Enron had filed for bankruptcy.
17. Important terms
Bottom Line
Bottom line refers to a company's net earnings, net income or earnings per
share (EPS). Bottom line also refers to any actions that may increase/decrease
net earnings or a company's overall profit. A company that is growing its net
earnings or reducing its costs is said to be "improving its bottom line".
Special Purpose Entity
Also referred to as a "bankruptcy-remote entity" whose operations are limited
to the acquisition and financing of specific assets. The SPV is usually a
subsidiary company with an asset/liability structure and legal status that makes
its obligations secure even if the parent company goes bankrupt.
A corporation can use such a vehicle to finance a large project without putting
the entire firm at risk. Problem is, due to accounting loopholes, these vehicles
became a way for CFOs to hide debt. Essentially, it looks like the company
doesn't have a liability when they really do. As we saw with the Enron
bankruptcy, if things go wrong, the results can be devastating.