American International Group

Every business is ultimately driven towards making profits and creating value to the various stakeholders involved and banks are not an exception. With a quest to increase its profits and make stellar results, banks have landed up in trouble by lending more than 40 times the reserve capital creating a liquidity crunch. But the entire trouble that the banks face as a consequence is primarily a balance sheet problem. The value of the assets in the bank's balance sheet is 20-50% more than the actual market value of the asset. A typical example was the housing market where the price of houses dropped by nearly 30-50% depending on locations. Therefore marking the assets to market will not only erode the banks valuation but also will create a sense of panic among investors to withdraw their investments all at a time creating a liquidity crisis.

During the boom times the value of the assets were increasing and therefore banks were able to project very healthy balance sheets but once there was a feeling that the assets were going down in value, each one of them tried to offset the losses to other entities like Insurance Firms. E.g. American International Group (AIG) undertook the risk of debts going bad, and in exchange received regular payments from the banks similar to insurance premiums. Therefore the asset value in balance sheet remained the same but the banks insured themselves from failures. Therefore they reduced/removed risk from their books and freed up their reserves for lending even more money. Little did they realize that they just passed the buck from one institution to the other but on the whole there was serious erosion in value.

It is found that the Net Financial Investments for households turned negative in 1999(negative $3 trillions), and stayed that way through 2007 before it again turned positive in 2008. During the same period there was tremendous amount of capital inflow from countries like China and Japan which found its way through the US financial system. Therefore there was a case where there was too much money