Risky Business

Xiaofei Liao

MGMT 2850

March 8, 2013

Case Study #2 – Risky Business

THE SITUATION IN BRIEF

In spring of 2008, after the housing bubble had burst. Wall Street had gambled heavily on house mortgage especially risky ones. As the housing market crashed, fear crept in. Home mortgages are triggering fears of a financial meltdown on Wall Street.

It began with a rumor about Bear Stearns. The rumor said that Bear’s massive investments in sub-prime mortgages, what would become known as “toxic assets”. As the smallest investment bank on Wall Street, Bear Stearns looked vulnerable. This rumor led to really serious things happened. Bear’s stocks kept falling, finally Bernanke pushed back creating a shotgun marriage between Bear and JP Morgan, and Paulson went along as Benanke guaranteed the deal with a $30 billion dowry to cover Bear’s toxic assets. Unfortunately, in the summer of 2008, the toxic mortgages continued to eat away at every major Wall Street firm. The losses on housing are real. The losses on subprime mortgages are real. There is trillions of dollars of losses to the financial system as a whole.

The next crisis occurred  on Fannie Mae and Freddie Mac, the largest mortgage lenders in the world. Bernanke and Palson feared this could be a major catastrophe and they had to do something about it without nationalizing them. However, the sort of logic of events just led them down there.

Next, Lehman Brothers’s toxic mortgage contagion was loose. This time, Paulson chose to watch the Lehman meltdown. He’s show signs of bailout exhaustion. He made a decision that Lehman will be allowed to fail. It was actually very high stakes game of signaling that he was playing.

 He had literally just finished resolving the Fannie Mae&Freddie Mac problem. And Paulson was under immense political pressure. Paulson told Fuld if they don’t find a buyer immediately, this company will go under. But it appers Fuld never thought the gov.would let Lehman fail. Now moral hazard seemed to be driving Paulson’s decision. If Fuld didn’t sell his company, he would pay for Lehman’s greed. Then, Paulson made a decision that Lehman will be allowed to fail. It was very high stakes game of signaling that he was playing. Eventually, Lehman Brothers goes bankrupt, and the impact it brought to the economy is far more serious than Paulson believed.

With the credit market frozen, there was soon a new big company at risk. AIG plunging—the world’s largest insurance company. AIG had invested tens of billions of their insurance profits in risky investments tied to the housing market. AIG does not have money in the ban to support the commitments it made.  They promised to pay all these people millions of dollars if Lehman went bankrupt. AIG definitely need cash, but now the credit market was frozen. No one was lending money. Finally,  Bernanke lend AIG $85 billion. The united state gov. now controlled the world’s largest insurance company. We have effectively a full nationalization and the gov. taking an 80% ownership stake in AIG.