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Credit Crisis

Credit Crisis

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Published by vsparmar
The events of the 2008 credit crisis and their consequences will shape the investment
landscape for decades to come. Therefore, investors who wish to be successful need to
have a comprehensive understanding of the credit crisis and the changes it has produced
in the financial community. This tutorial will provide readers with a broad-based
overview of the credit crisis. It's an excellent starting place for developing an opinion
about the future of the global financial environment.
The events of the 2008 credit crisis and their consequences will shape the investment
landscape for decades to come. Therefore, investors who wish to be successful need to
have a comprehensive understanding of the credit crisis and the changes it has produced
in the financial community. This tutorial will provide readers with a broad-based
overview of the credit crisis. It's an excellent starting place for developing an opinion
about the future of the global financial environment.

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Published by: vsparmar on Jan 17, 2009
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06/24/2009

 
Credit Crisis: Introduction
The events of the 2008 credit crisis and their consequences will shape the investmentlandscape for decades to come. Therefore, investors who wish to be successful need tohave a comprehensive understanding of the credit crisis and the changes it has producedin the financial community. This tutorial will provide readers with a broad-basedoverview of the credit crisis. It's an excellent starting place for developing an opinionabout the future of the global financial environment.The tutorial begins with a brief history of Wall Street, an analysis of the differencesbetween investment and commercial banking, and an overview of the disappearance of the classic investment bank. In the second chapter, we'll discuss the crisis in more detail,provide a look at some famous historical crises and compare their causes with the 2008credit crisis. The third and fourth chapters will look more closely at the credit crisis; firstby examining its origins and then by analyzing the events that prompted its onset. Thetutorial will then provide an overview of the most important events that occurred duringthe credit crisis before examining governmental efforts to mitigate the crisis and preventthe systemic collapse of the financial system.We'll also examine the crisis's impact on financial markets and investors, and provide anoverview of its impact on the financial markets. You'll also find some timelessinvestment lessons that the credit crisis has reinforced and that can help you succeedthrough future market downturns.While this tutorial is as comprehensive as possible, readers should remember that thecredit crisis consisted of an amazing array of previously unimaginable events. In addition,future accounts of the credit crisis may differ somewhat from this tutorial, based upon theperspective that will come from examining events with additional hindsight.
 
 
Credit Crisis: Wall Street History
A historical understanding of Wall Street will provide a starting place for analyzing thecredit crisis that changed the financial landscape forever. Therefore, this first chapter willdiscuss the evolution of investment banking to provide a context to the remainder of thistutorial.
Under the Buttonwood Tree
Wall Street originated beneath a buttonwood tree, where a group of traders gatheredduring the late eighteenth century. Eventually, the New York Stock Exchange (NYSE)came to be headquartered on the corner of Wall and Broad Streets in lower Manhattan,and for many decades, the most prominent banks were located nearby. Although many of those banks are no longer physically located on Wall Street, the term is still used todescribe the securities and investment industries. (For more insight, read Where does thename "Wall Street" come from?)What began in the shade of a buttonwood tree has today evolved into a massive globalindustry. At the industry's peak before the credit crisis, financial firms made up 22% of the total market capitalization of the Standard & Poor's 500 Index (S&P 500). Evenabove and beyond its economic impact, the term "Wall Street" has come to symbolize aculture and a way of life that are instantly recognizable around the world.
Investment Banks and Commercial Banks
Commercial banking and investment banking have historically been separated.Commercial banks accepted customer deposits and made loans to businesses andconsumers. This was considered a safe and stable business with relatively low profitmargins. Investment banks helped raise money for companies and governments throughstock or bond sales, advised companies on mergers and acquisitions, and traded securitiesfor customers or their own accounts. These activities were considered riskier thancommercial banking, but profit margins were higher.This separation between commercial and investment banking began during the GreatDepression. Previously, individual firms were allowed to conduct both investmentbanking and commercial banking operations. However, as part of a plan to reform thefinancial system, the Glass-Steagall Act separated investment banking firms fromcommercial banking firms. While commercial banking firms grew to be much largercompanies, investment banks became the companies most closely identified with WallStreet. Firms such as Goldman Sachs, Lehman Brothers, Merrill Lynch, SalomonBrothers and Morgan Stanley eventually became the most prestigious investment bankson Wall Street. (To learn more, read What Was The Glass-Steagall Act?)In the 1980s and 1990s, many firms began to merge as the globalization of financialmarkets and increasing capital requirements prompted the creation of increasingly largercompanies. This trend culminated in 1999 with passage of the Gramm-Leach-Bliley Act,
 
which essentially reversed the Glass-Steagall Act. By allowing commercial andinvestment banking operations to once again occur within the same firm, the Gramm-Leach-Bliley Act facilitated the creation of the so-called "universal bank". Universalbanks such as Citigroup (NYSE:C), JPMorgan (NYSE:JPM), Barclays (NYSE:BCS) andUBS (NYSE:UBS) combined commercial and investment banking and use their massivebalance sheets to underprice the traditional investment banks. By the onset of the creditcrisis, the investment banking "bulge bracket" included not only traditional investmentbanks such as Goldman Sachs (NYSE:GS) and Morgan Stanley (NYSE:MS), but alsouniversal banks like Citigroup, UBS and JPMorgan.
The Ascent of Risk
In the not-too-distant past, the bulk of investment banks' business consisted of advisingcorporations on mergers and acquisitions, raising capital for companies and governments,and facilitating stock or bond trades for their customers. Over time, though, theprofitability of these activities began to decline as the investment banks faced increasingcompetition from emerging universal banks.Seeking higher profits, investment banks such as Goldman Sachs increasingly turned toriskier activities such as principal trading and investing to generate the bulk of theirprofits. Principal trading and investing occurs when a firm uses its own capital to investin the markets in hopes of generating profits. During good times, these activities can bephenomenally profitable, and many firms posted record profits in the years leading up tothe credit crisis. However, principal trading and investing also exposed Wall Street firmsto much higher risk. (To learn more about risk, see Financial Concepts: The Risk/ReturnTradeoff.)While investment banks were increasing the amount of risk that they took in theirprincipal trading, they were also becoming increasingly dependent on complicatedderivatives and securitized products. The complicated nature of these products allowedfirms with an expertise in them to generate large profits. However, derivatives andsecuritized products are also difficult to value; these difficulties would eventually resultin many firms having much higher levels of risk exposure than they had intended. (Formore on this, see Valuation Analysis.)
Disappearance of Investment Banks
At the start of 2008, Goldman Sachs, Morgan Stanley, Merrill Lynch (NYSE:MER),Lehman Brothers (OTC:LEHMQ) and Bear Stearns were the five largest stand-aloneinvestment banks. The companies had existed for a combined total of 549 years, butwithin the span of six months, they would all be gone.In March 2008, Bear Stearns teetered on the edge of bankruptcy. J.P. Morgan purchasedthe bank for $10 a share, a fraction of its all-time high of $172 a share. The purchase wasfacilitated by the Federal Reserve, which guaranteed a large portion of Bear's liabilities aspart of an effort to mitigate the potential impact of a Bear Stearns bankruptcy. Followinga tumultuous summer, Lehman Brothers succumbed to the credit crisis on September 15,2008, when it filed for the largest bankruptcy in U.S. history. The Federal Reserve had

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