Academic journal article Journal of Economics and Finance

The Impact of Government Intervention on the Stabilization of Domestic Financial Markets and on U.S. Banks' Asset Composition

Academic journal article Journal of Economics and Finance

The Impact of Government Intervention on the Stabilization of Domestic Financial Markets and on U.S. Banks' Asset Composition

Article excerpt

1 Introduction

The 2007-2009 financial crisis that spawned from various factors such as the housing boom, aggressive mortgage lending activity, financial innovation through the creation of new funding products, and an increased access to money and capital markets culminated with unprecedented U.S. government intervention in the financial sector. Cecchetti (2009) and others claimed that by the summer of 2007 it was clear banks and other financial institutions stood to lose billions of dollars from their exposure to subprime mortgage loans. In the advent of the housing boom, Watson (2008)mentions that riskier loans to less creditworthy borrowers became common, and thus the market of potential borrowers had expanded beyond traditional bounds using a variety of nontraditional mortgage contracts. The aforementioned author claims the development that had a strong impact on the credit problems during the financial crisis was the funding of uninsured mortgage credit to borrowers whose credit history prevented them from obtaining conventional loans. Many researchers argue the housing finance model was predicated on rising real estate prices. After several years of double-digit increases, fueled in large part by real estate investor purchases rather than homeowner purchases, the market appreciably softened. Factors that contributed to the weakening of the housing market included rising interest rates between 2003 and 2006 and a reduced pool of qualified homeowners.

The ensuing bust in the housing market impacted the financial markets since falling house prices contributed to rising mortgage loan delinquencies and an increase in home foreclosures. The growing uncertainty with respect to the value of banks' balance sheets was at the core of the financial crisis and was captured by sharp increases in money market rates. The rising uncertainty about the value of banks' balance sheets prompted banks to hoard cash as they became concerned about their continued ability to tap into the capital markets to cover funding requirements. Rising liquidity constraints that initially arose in the interbank markets and perceived increases in counterparty risk eventually led to an overall disruption in the capital markets. With the financial system on the verge of collapse as a result of the spillover effects from the housing bust, and given the threat of a sharp contraction in credit and bank lending, it was clear government intervention would soon emerge. Due to the weak response to the Fed's monetary policy actions that involved reductions in target and primary lending rates, the Fed experimented with innovative short-term bank lending programs designed to inject liquidity into the financial system. Other important government-led efforts included debt and deposit guarantees, large scale asset purchases, and direct assistance through the U.S. Treasury's Troubled Asset Relief (TARP) and Capital Purchase (CPP) programs. The purpose of these programs was to stabilize the ailing financial system and to restore investor confidence.

An interesting area of research that has received some attention is the U.S. government'sinterventioninresponsetothe2007-2009 financial crisis. Some researchers focus on the effectiveness (or lack thereof) of the Fed's short term lending programs (e.g., Taylor and Williams (2009) and Cecchetti (2009)), while others examine the impact of the government bailout programs on bank lending (e.g., Lei (2013), Ivashina and Scharfstein (2010) and Egly and Mollick (2013)). Other researchers explore the impact of the government intervention on the stock market and overall investor confidence (e.g., Subrahmanyam et al. (2011) and Huerta et al. (2011)). To gain an overall economic perspective of the government intervention, Veronesi and Zingales (2010) calculate the costs (i.e., cost to tax-payers) and benefits (i.e., increased value of banks' financial claims) of the government bailout and determine it was an overall success. …

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