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Global
Global Economic
Economic Crisis
Crisis
Impact on
on Business
Business
Impact
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Australia • Brazil • Japan • Korea • Mexico • Singapore • Spain • United Kingdom • United States
Global Economic Crisis: Impact on Business
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Printed in the United States of America
1 2 3 4 5 6 7 13 12 11 10 09
B u i l d i ng Up to the Current Crisis
Learning Objectives.
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By the end of this chapter, you will be able to:
ƒ Explain the important financial market regulation that came out of the Great
Depression of the 1930s.
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ƒ Describe why the rise of American consumerism
nsumerism took place after World War II.
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ƒ Describe why there was a drive for mortgage-backed securities during the first
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decade of the 21st century.
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ƒ Delineate how all of these historical
A events have led up to the current financial
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crisis.
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In January 2007, everything seemed to be going right for the U.S. economy and, by
extension, U.S. financialC
On January 24, 2007, the Dow Jones Industrial Index
F markets.
ended the day at 12,621.
This was the first time ever the Dow had climbed above
12,600 . As stockO
prices continued to increase, the Federal Reserve worried that the U.S.
Y
economy might
be growing too quickly. The Federal Reserve had raised its target for the
Fed FundsTRate from 5.25 percent to 5.50 percent six months earlier, in the hopes of
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cooling a red hot U.S. economy. Even with the higher interest rates, the economy was
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growing
than 4 percent a yyear, a rate many economists believed was
P at faster
unsustainable
for
an
economy th
the size of the United States.
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ƒ Elaborate on why the Savings and Loan crisis took place.
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By the fall of 2008, things had changed drastically. By November 12, 2008, the Dow
had fallen to 8,282, a 41 percent drop from its high of 14,164 on October 9, 2007. The
Federal Reserve had cut its target for the Fed Funds rate to a mere 1 percent, in a
desperate attempt to keep the economy from sliding into a deep recession.
What on earth happened? How could such a highly successful economy like that of the
United States in January 2007 find itself on the brink of a severe recession a mere few
months later? At this point, we must ask ourselves: Where is the U.S. economy headed?
As the old saying goes, “If you want to know where you are going, you have to
understand where you have been.” To learn why the current financial crisis occurred and
where the global economy is headed, we need to determine how we got here. In fact, to
fully grasp how we got to where we are, we have to travel back over seventy years to the
1 See http://www.mdleasing.com/djia.htm.
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Building Up to the Current Crisis
Great Depression of the 1930s. As the American society was coming to grips with the
economic catastrophe of the Great Depression, there was a call for greater regulation of
our financial markets. Many of these regulations are still in place, and understanding
them helps to frame the structure of the current financial crisis.
From the economic despair of the Great Depression, we moved to the post–World War
II economic expansion with its boom in the housing market. One of the main players in
this post-war housing boom is the Federal National Mortgage Association and later the
Federal Home Loan Mortgage Corporation, or as they are better known, Fannie Mae and
Freddie Mac, respectfully. The financial troubles of Fannie and Freddie are a
centerpiece of the current financial crisis.
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The current financial crisis is not the firstt crisis to have centered on the American
mortgage market. Over twenty years ago, the Savings & Loan crisis also focused on
entities that lent money to households to buy their homes. The outfall from the Savings
& Loan crisis sets the groundwork for the current global financial crisis. While our
current crisis has roots dating back over seven decades ago with the Great Depression of
the 1930s, the picture is by no means complete. Updates on this discussion can be found
on the web page that accompanies
mpanies this booklet.
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THE EARLY CALL FOR RE
REGULATION
CGULATION OF FINANCIAL
MARKETS: THE 1930S F
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From Flappers
to Breadlines
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The 1920s was a glamorous decade. The “Roari
“Roaring ‘20s,” as they were called, saw the
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rise
of
American
consumerism,
with
American
households buying a wide range of
Pgoods and services from new automobiles and household
appliances to radios and other
O electrical devices. Americans were able to buy these consumer goods thanks, in great
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P part, to the booming stock market of the times. The New York Times index of 25
industrial stocks was at 110 in 19242; by June 1929, it had risen to 338, and by
September 1929, it stood at 452. Thus, someone buying the index in 1924 would have
seen his or her investment grow by over 400 percent by September 1929.3 The flappers
with their trendy dresses, flashy zoot suits, and dancing the Charleston all night long
epitomized the carefree decade. However, the good times could not last forever. By the
end of the decade, the party that had been the Roaring ‘20s would collapse into the
Great Depression of the 1930s.
2 Gary Walton and Hugh Rockoff, “History of the American Economy,” South-Western College Publishing, 2004.
3 Charles Kindlegerger, The World in Depression, 1929–1939, Berkeley: University of California Press, 1973.
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The Global Financial Crisis and Business
The Depression witnessed the once vibrant American economy seemingly imploding
overnight. As the previously dynamic and ever-expanding economy contracted,
unemployment across the economy increased dramatically. No sector of the economy
seemed to be spared of the growing massive unemployment of the 1930s. The
unemployment of unskilled workers, skilled craftsmen, farmers, businesspeople, and
even executives increased rapidly. The unemployment rate that stood at only 4 percent
for much of the 1920s increased to 25 percent by 1932.
The carefree dancing flappers of the 1920s were replaced with long breadlines and soup
kitchens feeding the growing masses of unemployed of the 1930s. The once booming
stock market seemed to evaporate and take the rest of the economy with it. The fall in
the stock market was so dramatic that stocks lost 40 percent of their value in just two
months. The stock market crash caused increased
eased uncertainty over future income and
employment translated into a reduction of household spending on durable goods such as
automobiles and radios. 4
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The Call for Reform
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As the economy contracted and unemployment rose, there were cries from the American
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people for their elected leaders to “do something”
about the economic crisis. The
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election of President Franklin Delano Roosev
Roosevelt in 1932 marked a dramatic change in
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how the federal government would approach the crisis. Roosevelt and his fellow
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Democrats believed that the Depression and the resulting rise in unemployment was due
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to the rampant speculation in
the stock market and financial markets in general.
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Even before Roosevelt was
sworn in, Senator Ferdinand Pecora had begun hearings to
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examine the role theF
financial markets played in triggering the Depression. The Pecora
Hearings, as theyO
became known, resulted in sweeping new regulations of the financial
markets. Within weeks of taking office, the Roosevelt Administration called for a bank
Ywould close all of the commercial banks in the country for seven days;
holiday that
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passed R
and signed the Securities Act of 1933; and, perhaps most importantly, passed the
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Glass-Steagall
Act or Banking Act of 1933.
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ROThe Glass-Steagall Act accomplished three key things:
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ƒ It separated commercial banks (i.e., those entities that take deposits and make
loans) from investment banks (i.e., those entities involved with underwriting and
selling stocks and bonds).
ƒ It created bank deposit insurance.
ƒ It gave the Federal Reserve the power to limit the interest rates commercial banks
could pay on deposits.
The Glass-Steagall Act’s separation of commercial and investment banking was based
on the premise that if commercial banks were allowed to be involved in the selling of
4 Christina Romer, “The Great Crash and the Onset of the Depression,” Quarterly Journal of Economics, August 1990, Vol. 105, no. 3.
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Building Up to the Current Crisis
stocks and bonds, a conflict of interest could exist and ultimately make commercial
banks less safe.
The creation of deposit insurance was also designed to make commercial banks more
stable. With the advent of government deposit insurance, depositors at insured banks
could be confident that their savings were secure. Even if an insured bank failed, the
government’s deposit insurance would be there to ensure that savers would not lose their
money. However, in order to make certain that banks were not taking on too much risk,
government deposit insurance prompted the need for government regulation or oversight
of the banking system.
In addition, Regulation Q of the Glass-Steagall Act was enacted to give the Federal
Reserve the power to limit interest rates paid on deposits and to make the banking
system more stable by limiting the amount of competition between banks. The drafters
of the bill feared that if commercial banks competed for deposits, they would ultimately
engage in destructive competitive behavior. Thus, to limit the amount of competition,
banks were not allowed to pay interest on demand deposits (checking accounts) and had
a cap on what interest rates they could pay on savings accounts.
As time went by, other legislation was passed that increased and expanded the
government regulation of U.S. financial markets. The Securities Act of 1933 and the
Securities Exchange Act of 1934 created the Securities and Exchange Commission, or
the SEC, which is still today the main regulator of the bond and stock markets. In 1938,
Congress created the Federal National Mortgage Association, or Fannie Mae, to help
stabilize the home mortgage market. Se
See the boxed feature for details.
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A mortgage loan uses real estate as collateral for the loan. Collateral is the
pledge ofY
an asset to ensure repayment by the borrower. Collateral serves as
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protection for the lender in case of defa
default or nonpayment by the borrower. If a
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person
borrows
money
and
pledges
something as collateral and does not repay
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as
promised,
the
lenders
allowed
to
collateral in lieu of the payment.
PSo, a home mortgage loan, or what wetakewillthesimply
refer to as a home mortgage,
Fannie Mae & Freddie Mac:
Government Entities to “Semi-Private” Financial Intermediaries
O is when the borrower pledges a house as collateral on a loan. A first mortgage is
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when a lender agrees to loan money to a family or an individual so that they can
purchase a house.
Until the 20th century, mortgages were usually short term, lasting only about
five to seven years. During those years, the borrower would have to pay interest
on the money borrowed and repay the entire amount at the end of the period.
Thus, at the end of the mortgage, the borrower would have to try to find
someone or some entity to lend them the money again.
During the Great Depression, many people lost their jobs and could not
afford to make their monthly mortgage payment, leaving the borrower to
foreclose on them and have the family evicted from their home. With the federal
government creation of the Federal National Mortgage Association (i.e., Fannie
Mae), borrowers were encouraged to lend money to families over a period of 30
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The Global Financial Crisis and Business
years. Over these 30 years, both interest and the loan principle would be paid.
At the end of the 30-year mortgage, the borrower would own the home outright.
To entice lenders to loan money for home mortgages, Fannie Mae would
agree to buy certain “qualified” mortgages from banks. Fannie Mae would then
either hold the mortgages or sell them to interested investors. In doing so,
Fannie Mae would free up funds for the lender to loan on new mortgages.
Due to budget constraints, President Johnson privatized Fannie Mae in
1968. In order to ensure that Fannie Mae did not have a monopoly in the
mortgage securitizing business, the federal government created the Federal
Home Loan Mortgage Corporation (i.e., Freddie Mac) in 1970.
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Since both of these entities were created
ed by the Federal government, many
in the financial markets believed that Fannie and Freddie enjoyed a government
guarantee against failure. Because of this “implied” government guarantee,
Fannie and Freddie could borrow money at very low interest rates in financial
markets.
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The financial market regulation that came E
out of the Great Depression seemed to work
very well. As the U.S. economy recovered
from the Depression, financial markets
G failures
remained stable and the number of banking
dropped significantly. During World
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War II, the U.S. financial marketsG
allowed the government to issue war bonds to finance
the wars in Europe and the Pacific.
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BUILDING THE AMERICAN
DREAM: U.S. HOUSING
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BOOM IN POST-WAR
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Pent Up Consumption During World War II
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PR The Second World War was a very hard time for American consumers. While household
income increased, household spending decreased significantly. This reduction in
household spending was in part necessary, as scarce consumer goods were diverted for
the war effort. Many consumer goods, including sugar, meat, gasoline, tires, and even
clothes, were rationed during the war. To buy these rationed goods, a family would need
not only cash but a government-issued ration coupon. Even having a ration coupon did
not guarantee that a consumer could find the good available for sale on store shelves.
Shortages of popular goods, especially sugar, were commonplace during the war.
While consumer goods were scarce during the war, one thing was not in short supply:
jobs. Workers were needed to build the tanks, ships, and arms that were critical to the
war effort. The production of many consumer goods was suspended so that resources
could be used for the war effort. For example, there were no new automobiles built in
the United States between the end of 1942 and 1946, since the factories that built
automobiles were converted into plants for making tanks, aircraft, artillery, etc., for the
war. Similarly, no new farm tractors were built during the war, as those factories were
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Building Up to the Current Crisis
likewise converted for the war effort. But these factories needed workers to produce
war-related products. Because many young males had joined the military to fight in the
war, workers were in short supply. For the first time in U.S. history, large numbers of
women entered the labor force.
As employment increased during the war, American households saw their incomes
increase. However, with the war rationing in effect, households had very few things on
which to spend this new income. Instead, scores of Americans saved their money during
the War, waiting and hoping for a better future.
Unleashing American Spending
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The end of the Second World War saw a return
turn of American consumerism in grand
style. The long years of economic
mic hardship of the Great Depression were behind them,
as were the days of sacrifice during World War II. The American consumer had pent up
spending power that was being unleashed. For military personnel who were returning
from fighting the war overseas as well as those who had “fought the war on the home
front,” the end of the war created an opportunity to capture the “American Dream.” A
big part of that post-war “American Dream” was home ownership. In 1940, just 44
percent of families owned their own home; by the end of the 1950s, three out of five
families owned their home (according to a U.
U.S. Census). This remarkable increase in
homeownership was due, in great part, to the expansion of the Savings and Loan
industry.
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Savings and Loans are depository institutions that take deposits, mostly from
households, and make loans mostly to consumers; these loans are often home
mortgages. While the Savings and Loan industry has a long history in the United States
going back to the 19th century (the forerunners were called Building & Loans), a
number of Savings and Loans failed during the depression. As a result, in 1932,
Congress passed the Federal Home Loan Bank Act of 1932, which created the Federal
Home Loan Bank Board to lend money to Savings and Loans that found themselves
short of funds. In 1934, Congress created the Federal Savings and Loan Insurance
Corporation (FSLIC), which would offer government deposit insurance to savers at
Savings and Loans.5
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Expansion of the Savings and Loan Industry
During the post–World War II era, the Savings and Loan industry thrived. The first
decade after the Second World War saw the Savings & Loan industry grow at its fastest
rate ever. The expansion of American suburbs during the late 1940s and 1950s increased
the demand for home mortgages that the Savings and Loans were prepared to offer. In
addition, the Savings and Loan trade association worked with the managers of the S&Ls
5 David Mason, “From Building and Loans to Bail-outs,” Cambridge University Press, 2004.
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showing them how to advertise their services and focus on providing a high level of
consumer service. As a result, the size and reach of the Savings and Loan industry
expanded greatly.
Government regulation of the Savings and Loan industry also played a large role in the
industry’s expansion. Thanks to Regulation Q, which the Savings and Loans became
subject to in 1966, the Savings and Loans faced a cap on their cost of funds. At the same
time, government regulations were changing, making it easier for the Savings and Loans
to offer even more mortgages and grow even more quickly. These were very successful
times for the Savings and Loans. Managers of the Savings and Loans lived by the “3-6-3
Rule,” that is, pay 3 percent on deposits, lend the money at 6 percent on mortgages, and
be on the golf course by 3:00 pm.
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The “3-6-3 Rule” illustrates why the Savings and Loans were so profitable. When a
depository institution pays 3 percent for deposits and lends the money out at 6 percent,
the difference between the two is what economists
sts call the “interest rate spread.” For the
Savings and Loans, the 3 percentage point interest rate spread is how they paid their
expenses and generated a profit. During the decades after the Second World War, the
Savings and Loans were very profitable indeed. These profits allowed existing Savings
and Loans to expand and drew in a large number of new S&Ls. By 1965, the Savings
and Loan industry held 26 percent of all consumer savings and provided 46 percent of
the single-family mortgages in the United St
States. Unfortunately, the good times would
not last forever.
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The Savings &CLoan Crisis of the 1980s
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Inflation and Interest Rates
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During theT
1970s, the U.S. ec
economy suffered from increased rates of inflation. Inflation
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is defined
as the continuous increase in the general level of prices. A high rate of
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inflation mean the cost of living for households increases and the cost of operations for
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firms increase. In addition, as the rate of in
inflation increases, market interest rates also
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To see why this happens, think about how you would feel if you were a lender of money
and prices increased. Suppose I ask you to lend me $2 so that I can buy a bottle of diet
Coke from a vending machine and agree to repay you tomorrow. . Essentially you are
lending me enough resources, the two dollars, to purchase an entire bottle of diet Coke.
Now assume the person who refills the vending machine changes the price of a bottle of
diet Coke from $2 to $3. Tomorrow comes and I give you $2. You say, “Wait a minute-I gave you enough resources to buy an entire bottle of diet Coke, and yet you pay me
back with resources that can now only buy two-thirds of a bottle of diet Coke!”
Notice what happened: When prices increase, or there is inflation, lenders get paid back
in money that simply no longer buys as much. As a result, if lenders think there is going
to be inflation, they are going to demand to be compensated for the difference and thus
demand a higher interest rate before they will lend their money.
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Building Up to the Current Crisis
This is what happened during the 1970s. As the inflation rate in the United States
increased, market interest rates also increased. Thus, interest rates on Treasury bills,
corporate bonds, and other types of debt increased higher and higher as U.S. inflation
got worse and worse.
The Problem of Disintermediation
One set of interest rates that did not increase during the 1970s was that paid by the
Savings and Loans. Remember that during this time, the Savings and Loans were
subject to Regulation Q, the law that stated the maximum interest rate that could be paid
on deposits. Thus, while the market interest rates on regular passbook savings accounts
could be no higher than 5.5 percent, the yield on a 1-year Treasury bill was over 12
percent by February 1980. As a result of thesee interest rate differences, savers started to
pull their money out of the Savings and Loans in favor of higher paying money market
mutual funds. The process of funds moving from one financial intermediary to another
is what economists call disintermediation.
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To combat disintermediation, the Savings and Loans looked for ways around Regulation
Q. One “invention” was the creation of NOW, or negotiable orders of withdrawal. NOW
accounts were essentially demand deposits that paid a market rate of interest. Initially
the NOW accounts were of questionable legal
legality, since they were violating the premise
of Regulation Q that prohibited the paying of interest on demand deposits or checking
accounts. But the operators of Savings and Lo
Loans thought they had little choice but to
offer the NOW accounts. If they did not offe
offer NOW accounts, they would see more and
more deposits leave their institutions. If the disintermediation were allowed to go on
unchecked, it would lead to a collapse of the Savings and Loan industry, since a
depository institution with no deposits simply can not function. Clearly, something
needed to change.
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PTheESavings and Loan industry turned to Washington for help with disintermediation. In
DIDMCA: The Solution that Did Not Work
O response to the growing financial market difficulties, after much debate, Congress
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Monetary Control Act (DIDMCA) in 1980. The DIDMCA was the Carter
Administration’s attempt to bring about some type of financial market reform. Four
years earlier, Carter had campaigned on the promise that his administration would bring
about such reform, but by 1980, little to nothing had changed in terms of financial
market regulation. DIDMCA was about to change all of that.
Two of DIDMCA’s major reforms were that it set up for the complete repeal of
Regulation Q over six years and it would make it legal for Savings & Loans to offer
NOW accounts in order to fend off the disintermediation immediately. While DIDMCA
allowed the Savings and Loans to compete with the money market mutual funds for
deposits, it created a whole new set of problems. Savings and Loans generated most of
their income off the 30-year fixed interest rate mortgages that they had written in the
past. The vast majority of these mortgages paid the Savings and Loan a 6 to 8 percent
annual rate of interest. When the Savings and Loans were paying 3 to 5.5 percent on
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The Global Financial Crisis and Business
deposits, they enjoyed a positive interest rate spread. With the passage of DIDMCA, the
Savings and Loans would now be paying upwards of 14 percent on their NOW
accounts. That meant that the Savings and Loans would be paying 14 percent for funds
while earning only 6 to 8 percent on funds. Thus, the Savings and loans were suffering
from a negative interest rate spread.
Garn-St. Germain: Making a Bad Problem Worse
To get relief from their negative interest rate spread, the Savings and Loans returned to
Congress in 1981 and 1982 seeking help. In response to the industry’s cry for help,
Congress passed the Garn-St. Germain Depository Institutions Act of 1982. Garn-St.
Germain allowed the Savings and Loans to diversify their lending away from traditional
30-year fixed rate home loans and into shorter term, more profitable business loans. The
Act allowed the Savings and Loans to hold up to 40 percent of their assets in
commercial mortgages and up to 11 percent of their assets in secured or unsecured
commercial loans. In addition, many states, including California and Texas, significantly
reduced the amount of regulations on their respective state-chartered Savings and Loans.
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As a result of these reduced regulations and a desire to diversify their loan portfolios, the
Savings and Loans set off a business lending spree. The Savings and Loans wrote a
dizzying array of commercial real estate loans, include loans for high-rise office
buildings, massive suburban shopping mall developments, and retail strip mall
developments. In addition, many Savings and Loans started lending money for
alternative energy development such as windmill farms in the Texas panhandle. One
issue with this new lending is that many Savings and Loan lenders had little to no
experience in making such loans. As a resu
result, many loans were written where risk was
mispriced. Numerous office buildings were built that simply were not needed. Many
shopping centers never found enough tenant
tenants because they knew shopping centers were
not needed. For example, by 1986, nearly one-third of the office space in Houston,
Texas, sat unoccupied. As th
these spaces went unrented, the real estate developers who
built these buildings could not pay the loans they had taken out from the Savings and
Loans.
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The Zombie Savings and Loans
By the late 1980s, the Savings and Loan industry was riddled with insolvent institutions.
These institutions had written so many bad loans that they simply did not have enough
assets to make good on all of their deposits. These insolvent institutions, sometimes
called “Zombie institutions” because they were financially “dead,” should have been
closed down by their regulators. These regulators, which included the Federal Home
Loan Bank and FSLIC, instead chose to suspend the regulatory rules and allowed these
Zombie institutions to continue to function. This suspension of the regulatory rules,
called “Capital Forbearance,” allowed the Zombie institutions to continue in operation
and make more and more risky loans.
As the Zombie institutions were allowed to continue in operation, many of the Zombies
“infected” the healthy, well run institutions. A Zombie institution would compete with a
healthy institution for a loan customer by offering the customer a loan on very favorable
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Building Up to the Current Crisis
terms with a low interest rate and/or easy repayment terms. To compete, the healthy
institution would have to offer the loan customer similar terms or face being locked out
of the market. Thus, the healthy institution would have to behave like the Zombie
institution and essentially “become” a Zombie institution.
One question that has been raised is: why did the regulators allow the Zombie
institutions to continue in operation? One answer to this question is that the regulators
simply did not have the resources to close all of the Zombie institutions. Closing all of
the Zombie institutions would have required perhaps hundreds of billions of dollars to
pay insured depositors. Since the regulators did have the resources to close all of these
Zombie institutions, they allowed them to continue in operation.
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A second potential explanation to why the regulators allowed the Zombie institutions to
continue in operation was the political powerr some of the savings and loan operators
wielded. See the box below for one of thee more infamous examples of political
influence in the savings and loan crisis.
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Charles Keating and the Keating 5
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One reason many of the Savings and Loan regulators practiced capital
forbearance was the political influence of the Savings and Loan operators. An
example of this is what became known as the Keating 5. An Arizona real estate
developer by the name of Charles Keating was allowed to buy a Savings and
Loan in California called Lincoln Savings and Loan. When Lincoln Savings and
Loan started to suffer from disintermediat
disintermediation, Keating promised depositors that
he could offer them a “special account” that would pay an interest rate much
above what money market mutual funds would pay.
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Many of Lincoln’s depositors were elderly, and they questioned Keating as
Y of the “special accounts.
to the safety
accounts.” Keating reassured his elderly customers
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that the special accounts were fully insu
insured by the federal government. In fact,
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they
were
not.
The
special
accounts
were actual shares in his real estate
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development
in
Arizona.
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The regulators of Lincoln Savings and Loan at the Federal Home Bank
Board became concerned about the growing riskiness of Lincoln. But Charles
Keating did not want the regulators to interfere in his operations. Keating had
made large campaign contributions to five key U.S. Senators. Keating now
called on these five Senators to intervene with the regulators on his behalf. The
five Senators basically did what Keating requested. As a result, Keating was
allowed to continue to operate Lincoln Savings and Loan as he saw fit.
In 1989, Lincoln Savings and Loan failed, costing taxpayers $1.3 billion, and
more importantly, more than 22,000 depositors/bondholders at Lincoln Savings
and Loan lost their savings since they were not in government-insured accounts.
Charles Keating eventually was convicted of bank fraud and served four and a
half years in prison. What happened to those five Senators known as the
Keating 5? Basically, nothing. All were allowed to continue serving in the U.S.
10
The Global Financial Crisis and Business
Senate, and two of the Keating 5 went on to run for President of the United
States despite their questionable ethical dealings with Charles Keating.
As the 1980s moved on, the Savings and Loan problem grew significantly. In 1988, the
FSLIC had closed over 200 Savings and Loans that were insolvent. The problem,
however, was that by the end of 1988, over 500 insolvent Savings and Loans continued
to operate. Clearly, the current system had failed.
In August 1989, President George H. Bush signed the Financial Institutions Reform
Recovery and Enforcement Act. FIRREA was the first dramatic step to resolve the
Savings and Loan crisis. Among other things, FIRREA forced the absorption of the
FSLIC into the FDIC. In addition, the Federal Home Loan Banks’ independence was
stripped away and it was taken over by the Office of Thrift Supervision within the
Treasury Department. Perhaps most importantly, FIRREA created the Resolution Trust
Corporation (RTC), which was to close the insolvent Savings
Savings and Loans and sell off
their assets.
G
N
I
N
R
A
LE
The once proud Savings and Loan industry that had helped to build the American
suburbs after the Second World War was now a mere shadow of itself. The inability or
unwillingness of the Savings and Loan operators to measure the riskiness of their loans
problem greatly contributed to the industry’s demise. The regulators such as the Federal
Home Loan Bank and FSLIC arguably did not do their job correctly, and these entities
were either stripped of their powers or completely eliminated.
E
AG
G
N
E
C
F 2002–2006
THE SEEKING OF RETURN:
Y
T
R
O
One of the lessons learned from the Savings and Loan crisis is that depository
institutions that rely on the interest rate spread between what they earn on long-term
loans and what they pay on short-term depos
deposits can suffer greatly when market interest
rates increase. The Savings and Loans suffer
suffered from negative interest rate spreads
throughout the late 1970s and early 1980s, and these negative spreads triggered a series
of chain reactions that ultimately led to the current financial crisis.
PE
O
R
P
Banks and Fee Income
In an attempt to avoid a repeat of the Savings and Loan crisis, commercial banks in the
United States during the 1990s and throughout the first decade of the 21st century
attempted to end their reliance on interest rate spreads. Instead of depending on the
spread as a source of profits, commercial banks envisioned themselves as providers of
financial services who earned fees for their services. Since fee income was independent
of changes in market interest rates, commercial banks saw it as a much more stable
source of income and profits.
Commercial banks looked in a variety of places to generate fees. They charged fees for
use of ATMs (automated teller machines), for use of the bank lobby, and for printing
11
Building Up to the Current Crisis
checks, and they looked at offering new services where they could generate new fees.
One expanding market that caught the banks’ attention was the home mortgage market.
Traditionally, when a depository institution wrote a home mortgage loan, the depository
institution would hold the mortgage, collect payment, or service the mortgage for 30
years until the household borrower paid off the mortgage. However, in their desire to
earn fees, commercial banks were turning more and more to the securitization of home
mortgages.
Securitization
Securitization is the pooling or combining of loans, such as mortgages, into one big
bundle. This bundle is then used to create a new financial instrument or bond whose
cash flows are the original loans in the pool.. For example, the securitization of home
mortgages entails the purchase of a large number of home mortgages and the creation of
a mortgage-backed security, or MBS. The mortgaged-backed securities are paid the cash
flow received from the households as they
ey make their mortgage payments.
G
N
I
N
R
A
E
LE
Securitization takes place with other loans in addition to home mortgages. Commercial
mortgages are also securitized into their ow
own version of securitized securities called
Commercial Mortgaged-Backed Assets. Student Loans are also securitized. If you have
borrowed money for a student loan, once you si
signed your promise to repay the loan, the
bank or financial institution that lent you the money took your student loan, bundled it
with other student loans, and created an A
Asset-Backed Security, or ABS. In 2006, $79
billion of new student-loan-backed ABS were issued, with the total market size
estimated to exceed $350
$350 billion in 2007.
AG
G
N
E
C
F
O
Fannie Mae and Freddie Mac: Their Great Demise
Y
Fannie T
Mae and Freddie Mac were originally created by Congress to provide
liquidity
to the mortgage market, and they were very successful. They did so by
R
buying
“qualified”
mortgages and securitizing them, or bundling them and selling
E
Pthe bundles to investors. The two “gov
“government-sponsored entities,” or GSEs,
O came to dominate the mortgage market. Together they hold or guarantee over
R
P $5 trillion in mortgages. By comparison, the entire U.S. economy is just over $13
trillion and the total entire outstanding mortgages in the United States amount to
$12 trillion.
However, in 2007 and 2008, both Fannie Mae and Freddie Mac ran into a
great deal of financial trouble. Both Fannie and Freddie had purchased
mortgages without carefully examining the default risks associated with those
mortgages. As a result, in 2008, the federal government had to take over both
Fannie and Freddie to keep them from failing.
When a commercial bank writes a loan that will be bundled up or securitized, the bank
earns a fee from the entity that does the bundling. The “bundler” or securitizer may be
an investment bank, a Government-Sponsored Entity (such as Fannie Mae, Freddie Mac,
or Sallie Mae--for student loans), or a Special Investment Vehicle, which is created by
commercial banks. The bundler then sells the newly created asset, such as a mortgage12
The Global Financial Crisis and Business
backed security, to an institutional investor, such as an insurance company, pension
fund, or an endowment.
G
N
I
Over time, the market for mortgage-backed securities increased.
eased. The loan originators,
oftentimes commercial banks, liked the process of making mortgage loans and earning a
fee and then servicing the mortgage and earning more fees. They could generate fee
income and move the long-term mortgages off their balance sheet, so they no longer had
to worry about interest rate spreads. The process was appealing too because it enabled
the mortgage bundlers to charge a fee for bundling the mortgages together and then
selling them to institutional investors.
N
R
A
E
AG
LE
As time went on, new inventions in the mortgage market came about. One issue that
arose was that not all institutional investors had the same desire for risk. Some
institutional investors didn’t want any risk of de
default. That is, they wanted to be sure that
they received the payments they were expect
expecting. At the same time, other institutional
investors were more willing to take on some risk, as long as they were compensated for
this increased risk by being paid a higher interest rate.
Y
T
R
F
O
G
N
E
C
To meet the differing needs of these institutional investors, the bundlers of MortgageBacked Securities decided to slice the MBSs into different pieces. The first slice would
be paid first, as the households made their mortgage payments. The next slice would be
paid after the first slice was paid, if there was still money left over, meaning if there
were only a few or no defaults. Each of th
the remaining slices would then be paid in
descending order. These slices of the MBSs are called tranches, from the French word
tranch, which means slice.
PE
O
R
P
In reality, there could be more than just three tranches, but the logic remains the same:
the senior tranche gets paid first and so on down the line. Some of the lower tranches,
the last to be paid and thus the most risky, the lenders (including commercial banks)
held onto the mortgages since they could be very difficult to sell to institutional
investors. But, as long as there are no defaults on mortgages, all of the tranches get paid.
13
Building Up to the Current Crisis
Historically, home mortgage defaults were very low, only around 2 percent, so the
buyers of the Mortgage-Backed Assets felt fairly safe that they would receive their
payments as promised. Thus, the securitized mortgage market grew.
Falling Market Interest Rates
In 2001, in a response to a slowing U.S. economy, the Federal Reserve set out to lower
interest rates to stimulate the economy. The collapse of the dot.com boom in 2001 had
brought about a significant reduction in the amount of household and business spending.
To encourage more borrowing and spending by households and firms, the Federal
Reserve cut interest rates throughout 2001, 2002, and 2003. By 2003, market interest
rates in the United States were the lowest
west they had been in forty years.
G
N
I investors’ interest rates in
In response to these falling market interest rates, institutional
N
the home mortgage market increased significantly. While other market interest rates had
R
dropped significantly due to the Federal Reserve’s actions, the interest rates on home
A
mortgages, and thus the return on mortgage-backed
securities, had not fallen as much.
LE investors to buy these mortgageThus, there was a growing interest by institutional
backed securities.
E
G
The mortgage lenders, including A
commercial banks, were desperate to the meet the
G
growing demand for mortgage-backed
assets. But in order to create more mortgageN
backed assets, these lenders needed to wr
write more and more mortgages. The problem
these lenders faced was E
that in order to writ
write more mortgages, they would need to go
beyond “traditional” C
borrowers. That is, the lenders needed to lower their lending
F
standards so that more
O people could qualify for mortgages.
Y if a family wanted to borrow money to buy a house, they needed to have
Traditionally,
T
20 percent
of the purchase price in cash. The family could then borrow the remaining 80
R
percent of the purchase price of the house via a mortgage. But, as the demand for
E
assets increased, mort
mortgage lenders began writing “zero-down”
Pmortgage-backed
mortgages where the borrower puts no money down and borrows 100 percent of the
O purchase price.
R
P
One potential problem with “zero-down” mortgages is that they can result in much
higher default rates. In the traditional 20-percent down mortgage, the borrower has some
of their own money in the house, or as the saying goes, they have “their skin in the
game.” If times become financially difficult for the borrower, they would work hard to
stay current on their mortgage payments, since defaulting on the mortgage or being
foreclosed on would cause the borrower to lose the money they had used to purchase the
house. However, with zero-down mortgages, the borrower doesn’t have any “skin in the
game” or any financial interest in the house. Under this setting, if financial times
become difficult, the borrower is much more likely to simply walk away from the house
and have the lender foreclose on the house.
Thus, the advent of the zero-down mortgage greatly increased the probability of default
by the borrowers. The problem is, many in the financial markets ignored these
increasing risks in the mortgage market. Instead, they continued to believe that mortgage
14
The Global Financial Crisis and Business
default rates would stay exactly as they always had been. In other words, there was a
major mispricing of risk occurring in the U.S. mortgage markets.
Heads I Win, Tales the Government Loses
As depository institutions such as Savings and Loans or commercial banks take on more
risk, either through writing risky loans or holding risky assets, depositors usually
“punish” this behavior by withdrawing their deposits. Depositors do this because if the
depository institution fails due to too many of its risky assets failing to pay out as
planned, the depositor will lose all of the money they have on deposit. In these cases, the
depositors essentially “watch over” the depository institution and help to ensure that
Savings and Loans or commercial banks do not engage in excessive risky behavior.
G
N
I
However, deposit insurance changes all of this. With government-sponsored
deposit
N
insurance, the depositor knows that even if the depository institution fails, the depositor
R
will not lose any of their money. If the institution fails, all the depositor has to do is go
A
to the government to get a check equal to the amount
of the government insurance.
LE
On the other hand, if the depository institution
E engages in holding risk assets and these
risky assets pay off, the institution can G
“share” these high payoffs with the depositor in
the form of higher interest rates on A
deposits. This is what economists call the “moral
G
hazard” of deposit insurance. A moral
hazard is the existence of a contract that can alter
N
behavior by changing incentives.
E
C
With the creation of government deposit insurance, the incentives and behavior of
F no longer “watch over” depository institutions to “keep
depositors change. Depositors
O
them safe” and instead have an incentive to push lenders to hold very risky assets. If
Y pay off as planned, the depositor benefits, as the institution shares with
those risky assets
T
them the high
returns generated by the risky assets. Conversely, if the risky assets fail to
R
pay off as planned and the depository institution fails, the depositor turns to the
E to be made whole again. From the point of view of the depositor,
government
P
government-sponsored deposit insurance creates a situation where the depositor can say
O
R “head I win, tails the government loses.”
P
BRINGING IT ALL TOGETHER
The current financial crisis that centers on the home mortgage markets has its roots in
the evolution of the U.S. financial markets. Many economists argue that the deposit
insurance that was created during the Great Depression of the 1930s may have
contributed to the excessive risk taking and the mispricing of risk in the home mortgage
market during the first decade of the 21st century. What contributed to this mispricing of
risk in the home mortgage market was the rapid expansion of the securitizing of home
mortgages, which was an outcome of the Savings and Loan crisis of the 1980s. But this
securitization would not have been possible without the rapid expansion of the U.S.
housing market in the decades following the Second World War.
15
Building Up to the Current Crisis
But the synopsis of the current financial crisis is not complete. In the next chapter, we
will examine in more depth the issues of the current crisis. Updates on the current status
of the crisis can be found on the web page www.cengage.com/gec that accompanies this
booklet. It will be very interesting and informative to watch this crisis unfold.
G
N
I
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R
A
E
AG
Y
T
R
PE
O
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P
16
F
O
C
G
N
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LE
I m p a c t o f T h e G l o b a l E c o no m i c C r is is o n
Business
Learning Goals
G
N
I
ƒ What is a “flight to safety,” and how has it impacted world economies?
N
R responded to the global
ƒ How have governments and international organizations
A
economic crisis?
LtheE economic relationship between the
ƒ How does the global economic crisis aff
affect
ect
U.S. and China?
E
G
ƒ How are small businesses impacted by the crisis, and why are they challenged with
A
cash flow problems?
G
N including the Federal Reserve, doing to combat the
ƒ What is the U.S. government,
E
crisis?
Ccrisis impacting corporate compensation, including wages
ƒ How is the economic
F
and bonuses?
O
ƒ What isY
the impact of the crisis on union power and union-management
T
relationships?
R
ƒ EHow has the crisis influenced both the luxury and discount markets?
P
After reading this chapter, you should be able to answer these questions:
P
ƒ
O
R
How is the crisis impacting the ability of companies to raise money through both
the debt and equity markets?
17
Impact of The Global Economic Crisis on Business
THE GLOBAL ECONOMIC CRISIS AND GLOBAL
BUSINESS
The Concept of Decoupling—The Theory That
Didn’t Happen
The period 2003 – 2006 was a boom time for the global economy. The post WWII
period had been marked by U.S. economic dominance of the global economy. As the
saying went, “When the U.S. sneezed, the world
rld caught a cold.” For decades, the
downturn in U.S. consumer and business demand invariab
invariably led to global recession.
With U.S. consumers and businesses demanding less of the raw materials, agriculture,
and manufactured products produced in Europe,
ope, Asia, South America, and Africa, those
regions suffered declines in their economies
mies mirroring those in the U.S.
G
N
I
N
R
A
LE
By 2005, so the theory went, all that had ch
changed. With the emergence of a new set of
strong global economic players, led by Chin
China, India, and Russia, and the increasing
strong economic and trade position of dozens of other emerging economies, the theory
emerged that the global economy had “decoupled” from U.S. dependence. Under the
theory of decoupling, demand generated by consumers within these emerging
economies, and cross trade between them, would insulate the regional economies from
an isolated U.S. downturn. Chinese consumers would buy Chinese goods. Indian
consumers would buy Indian goods. They’d both buy each other’s goods. The U.S.
might stumble, but this wouldn’t mean that other countries would suffer too.
E
AG
G
N
E
C
P
F
O
Events
in the second half of 2008 have demonstrated that, far from being decoupled,
Yeconomies
global
are more inte
interdependent than ever. The economic crisis that started
T
R
with the bursting of the U.S. housing bubble (an overvaluation of an asset) has spread
E
O
R
P
rapidly, disrupting economies from Iceland to Pakistan. China, for example, has seen
its Purchasing Managers Index of Manufacturing Activity fall sharply in the past two
months.i Far from finding themselves immune from the U.S. crisis, many less developed
economies now find their currencies threatened as their balance of payments (the excess
of what is owed by the country over what is owed to the country) deteriorates. A
declining balance of payments can threaten currency stability, moving the value of a
country’s currency downward and making it even harder to pay foreign debts.
More advanced countries including England, Germany, and China have scrambled to
shore up their banking systems as the devaluation in housing hits their own balance
sheets. It thus appears that the world over, countries big and small are more than ever
bound together by economic interdependence.
The Global Capital Flight to Safety
One result of the worldwide economic downturn has been a capital flight to safety that
has a devastating impact on economies around the world. In a flight to safety, investors
18
The Global Financial Crisis and Business
shift capital (money) from investments they perceive to be risky, such as stocks, into
investments that appear to be “safe harbors,” that is, they are likely to hold their value
during a time of economic turmoil. Often the safe harbor may be an asset like gold, and
during the first half of 2008, gold prices indeed soared, rising over $200 an ounce
between July 2007 and July 2008.ii With the general decline of commodity prices in the
final half of 2008, however, gold too has lost its luster.
While the U.S. is at the epicenter of the current financial crisis, it has become the safe
harbor of choice for investors around the world, driven by the perception that the U.S.
government will not allow a default on its debt obligations. The result has been
enormous inflow of funds into the U.S. as investors have sought to purchase U.S.
treasury bonds, considered one of the safest investments.iii
Turmoil in Exchange Rates and the Impact on
Countries and Business
NG
I
N
R
This so-called flight to safety has resulted in a strengthening of the dollar against most
major currencies, as world investors shift out of investments denominated in other
currencies to U.S. dollar denominated treasury bonds. While foreign currency
devaluations (a drop in the price of one currency compared to another) have both good
and bad effects for the country in question, two immediate imp
impacts are the rising costs of
foreign goods in the country in question and the increasing difficulty of servicing foreign
debt, which is often denominated in U.S. doll
dollars. This puts foreign governments under
risk of default at a time when falling consumption is already leading to a drop in tax
revenues. The Ukraine, for example, has rrecently entered into a full-blown financial
crisis as citizens attempt to convert their currency into the U.S. dollar.iv
E
AG
F
O
A
E
L
G
N
E
C
Business is also impacted by the shifting exchange rate landscape:
Y
T
R
ƒ U.S.-based business sells at a disadvan
disadvantage to countries with depreciated
currencies since a strong U.S. dollar makes U.S. produced goods more costly.
PE
O
R
P
ƒ Foreign profits that are repatriated (retur
(returned) to the U.S. bring in fewer dollars
because of the currency weakness in the originating country. One estimate
suggests that the comparatively strong dollar will shave 2% from profits at
fortune 500 companies in 2009.v
ƒ Foreign-based business may have a cost advantage, although that may also be
somewhat offset by higher prices for imported materials needed in production.
ƒ All business suffers from difficulty in financial planning when rapidly changing
foreign exchange rates result in the unpredictability of cash flows.
Global Responses to Economic Turmoil
The global economic crisis has shifted the focus of financial management from private
financial institutions to governments. Governments have taken several steps to combat
the crisis, both alone and in coordination with other governments:
19
Impact of The Global Economic Crisis on Business
ƒ Coordinated interest rate reductions - Global institutions have moved quickly to
address the issues that include collapsing asset bubbles (housing, metals, etc.),
capital flight, bank failure, and faltering consumer spending. Governments have
responded with both monetary tools (e.g. rate cuts) and fiscal tools including
capital injections into markets. In the U.S., actions of the central bank, the
Federal Reserve, and the Treasury Department have included rate cuts, direct
capital infusions into banks and insurance companies, and the $700 billion socalled “bailout” package.
ƒ Interest rate cuts, which are designed to stimulate the economy by expanding the
money supply, are typically undertaken by individual governments. As recently
as October 6th, 2008, the Wall Street Journal pointed out that coordinated rate
reductions are seldom used by governments.vi Since then, there have been several
instances of coordinated reductions involving the U.S., Canada, Great Britain,
Germany, China, and others. At the same time, governments have cooperated in
the setting of deposit insurance limits, which dictate the amount of deposit money
protected by the government in the case of bank failure, to eliminate potential
competition for deposits among world banks.
G
N
I
N
R
A
E
L
The Newly Empowered
E IMF
G
The International Monetary A
Fund (IMF) was established near the end of WWII to
stabilize foreign exchange
Grates. Stable exchange rates help both governments and
businesses in financialN
planning. One typical role of the IMF in the past was to give
loans to countries atErisk of default on their foreign debts (which tends to weaken the
C while at the same time ininsisting on reforms to stabilize the receiving
country’s currency)
F As recent
country’s economy.
recently as the beginning of 2008, the IMF was casting about
for a newO
role in the world economy as the foreign reserve accounts (the funds used to
pay foreign
Y debts) for many newly emerging countries appeared strong and the need to
T
loan
R funds no longer existed. The IMF seemed an institutional dinosaur of the past. In
the period August–November, 2008, the IMF has emerged as a newly influential and
E
P powerful international institution, granting loans to shore up the faltering economies of
RO
P
countries such as Iceland and Pakistan, and even announcing a program to lend up to
$100 billion to help the credit flow in otherwise healthy countries.vii
China on the Ropes? The Codependency of
China and the U.S.
The period leading up to the 2008 global economic crisis has witnessed a growing
codependency of the U.S. and Chinese economies. In the period 2000–2007, imports of
goods from China to the U.S. grew from just over $100 billion annually to $321
billion.viii With the outsourcing of a significant percentage of industrial production to
China, the U.S. has become increasingly dependent on China for the flow of goods
demanded by U.S. consumers. China, in turn, has become highly dependent on U.S. and
European consumer demand to fuel their continued job growth. The cycle doesn’t stop
there. The surplus foreign exchange reserves earned by China when it sells consumer
goods to the U.S. are, in turn, invested by China in U.S. Treasury Bonds. Up until
20
The Global Financial Crisis and Business
recently these reinvested funds pumped dollars into the U.S. economy. That money kept
interest rates low, triggering more borrowing and fueling consumer demand for Chinese
goods. This cycle has led to the explosive growth in the Chinese economy of 9% per
year on average over the past 25 yearsix along with their enormous investment in U.S.
Treasury bonds.
The global economic crisis threatens to break this virtuous economic cycle. While
Chinese economic activity is sometimes hard to fully gauge due to lack of transparency
in Chinese government reporting (i.e. the lack of clear and open reporting), it appears
that the growth rate has fallen from a high of 11.9% in 2007x to a projected 7.5% in
2009.xi While this is still high compared to U.S. and European growth rates of 1 – 3%
(before the current economic downturn), it is estimated that China needs growth in
excess of 8% to sustain current employment levels given the population growth and the
shift of population from the rural areas
eas to the industrial east coast.xii
The Chinese
government worries about the impact of unemployment, and indeed, there have been
recent reports of growing
ing labor unrest as the economy slows.xiii
G
N
I
N
The Specter of Trade Protectionism
R
A
E
As global trade has fallen off, free trade governments have been increasingly worried
L
about new restrictions on global
obal trade such as rising tariffs (a tax on goods entering a
country), which threaten to further stifle economic
ecE
onomic activity. Depression-era free trade
G
restrictions were a significant contributin
contributing factor in the depression era economic
A
collapse, and it was to fight those restrictions that the General Agreement on Tariffs and
G
Trade (GATT, later replaced byN
the World Trad
Trade Organization) was created at the end of
WWII. In Lima, Peru atEthe Asia-Paci
Asia-Pacific Economic Cooperation Conference in
November 2008, outgoing
U.S. president George Bush warned against the possibility of
Cbarriers
a new era of global trade
saying that “One of the enduring lessons of the Great
F
Depression is thatO
global protectionism is a path to global economic ruin.” Still, while
governments were scrambling to prop up their ailing economies, as of late 2008 there
Yto be an emerging global trade war.
did not seem
T
R
E
P
O
R
xiv
IMPACT OF PTHE GLOBAL
ECONOMIC CRISIS ON E-COMMERCE
Will E-commerce Struggle or Thrive?
Leading e-commerce companies are preparing for a downturn starting in the fourth
quarter of 2009.xv
As of early December 2008, it is still difficult to foretell the impact of the global
economic crisis on e-commerce. While online retail spending fell 2% in November
2008 over the November 2007 figure, spending on Cyber Monday (the first Monday
after Thanksgiving) was up 15% over the year earlier period. Still, reports indicate that
much of the increase in spending has been driven by deep discounting which will be
21
Impact of The Global Economic Crisis on Business
reflected in poor retailer margins and profitability in what is usually their most profitable
period.xvi
THE GLOBAL ECONOMIC CRISIS AND SMALL BUSINESS
The Cash Flow Crunch—Falling Demand and a
Failing Credit Market
Home values in many American urban areas have been falling since the middle of 2006,
and values of financial investments such as stocks and bonds dropped sharply in the
September–October 2008 period. This led to both a real and perceived drop in
household net worth. While some of the drop is a loss in paper value (a gain on an asset
that has never been cashed out—for example, a stock that rose from $10 to $25 per
share, then dropped down to $15 per share) that may well be eventually recovered, the
losses still have significant impact on consumer behavior for several reasons:
G
N
I
N
R
A
E
L
ƒ Whether the loss is real or not, the psychol
E psychological impact of the perceived fall in
household net worth causes consumers to cut back on discretionary expenses
G purcha
such as dining out, new
purchases, vacations, or home improvements.
Afurniture
ƒ Falling home valuesG
restrict credit from home equity loans. A home equity loan is
N
a loan from a bank
that is based on what the home is worth over what is owed on
the home and is one major source of credit funding for consumer purchases.
CE
ƒ Older and
need to draw down on their net worth (wealth) to
F retired Americans
fund
consumption
during
retirement,
including health care. For these Americans,
includ
O
the value of investments is more than paper value because they have no option to
TYwait out the market. (Whereas a younger worker can live off current income
R
E
P
O
R
P
while investment values recover, an older retiree must draw off of investments to
survive.) For many of these older Americans, the recent stock market decline
represents a permanent decline in their spending power.
ƒ As business gets hit by declining consumer demand (consumer demand makes up
over 70% of the U.S. economy),xvii companies have begun to shed workers. In
recent months the unemployment rate has shot up to 6.7% from a mid-decade low
of roughly 5%.xviii These newly unemployed workers are in much the same boat
as retirees, often forced to draw off of investments to continue paying for
mortgages, insurance, food, and transportation.
Credit Tightens as Banks Struggle to Preserve
Capital
Meanwhile the number of business loans is shrinking, with impact to both investment
capital (the money used to buy equipment, land, and other factors used in production)
and operating cash (the money used to pay payroll and cover day-to-day expenses). As
22
The Global Financial Crisis and Business
they reel from the impact of the global economic crisis, U.S. banks are in a struggle to
preserve capital as their balance sheets deteriorate. Federal regulations require banks to
preserve a certain level of assets to meet their obligations to bank depositors. When
assets shrink, banks may be caught in a position where they no longer meet regulatory
requirements. Banks have been caught with billions of dollars in real estate holdings
often through derivatives (a financial instrument that combines many assets such as
home mortgages into one asset that has a value and can be traded). As the underlying
home values decline, the derivative values drop, causing a drop in the asset side of the
bank’s balance sheet. This drop negatively impacts bank income and may result in a
drop in owner’s equity on the bank’s balance sheet. These events may cause the banks
to fall below the asset threshold required to support their liabilities, which include
deposits.
While it is theoretically still in the interest of banks to make loans, making an
underperforming loan (a loan that may default or be late in payment) further erodes the
bank balance sheet and income statement. Thus banks have significantly tightened
standards for lending, scrutinizing both business and consumers for credit risk and often
extending credit to only the most credit-worthy
orthy borrowers. For example, during the
August–October 2008 period, new loans from banks fell 36% from the previous threemonth period.xix
G
N
I
N
R
A
E
AG
LE
The Federal Reserve and the U.S. Treasury have attempted to break this cycle through
the $700 billion bank rescue package and the Troubled Asset Relief Program (TARP)
which have attempted to inject capital (money) into the banking system while removing
“toxic assets” (declining home-loan derivatives) from bank’s balance sheets. As of early
December 2008, the bank rescue package has done little to free up consumer and
business credit.
F
O
G
N
E
C
Businesses, both small and large, require cred
credit to meet ongoing operational cash flow
needs. For example, the sma
small Idaho company Sun Valley Shutters and Shades uses an
owner’s line of credit from Citibank to periodically pay for materials and labor for client
projects. The borrowed funds then get repaid once the client pays the bill for the project.
“If Citibank were to withdraw our line of credit for cost cutting purposes, doing business
would become much more difficult for us,” says the owner. Although small by global
business standards, the needs of Sun Valley Shutters and Shades illustrates the same
cash flow problems that threaten companies as large as Ford and General Motors.
Another company, Republic Windows and Doors, a Chicago-based business, has
become the object of nationwide attention after Bank of America cut off their line of
credit, threatening their ability to continue operations.xx
Y
T
R
PE
O
R
P
Consumer Credit Tightens Further, Restricting
Small Business Revenues
Furthermore, consumers’ ability to borrow is coming under increasing pressure as banks
tighten up on credit cards, home equity loans, auto loans, and college loans. Small
business revenues often depend directly on consumer spending habits, which are
invariably driven by easy credit in the modern economy. The less credit there is, the less
business for the small entrepreneur. No one is immune. For example DAN, a sole
proprietor men’s hair salon in Portland, Oregon, has seen business decline as customers
23
Impact of The Global Economic Crisis on Business
stretch out the time between haircuts, resulting in a drop in revenues and profits for the
owner.
The Ominous Potential for Deflation
One final threat to businesses large and small is the possibility of deflation. Deflation is
the opposite of inflation and is a protracted situation where the value of money (in the
case of the U.S., the dollar) actually rises. The effect is that the dollar buys more or, to
put it differently, prices drop. On the surface, deflation sounds like a good thing, but it
is actually very worrisome for business and financial regulators for a number of reasons:
ƒ Delayed purchases – If businesses and consumers both believe prices will fall,
purchases may be delayed to await better pricing. This is the same psychology
that causes a consumer to put off a holiday purchase until the post-Christmas
period when he knows the same product can be purchased less expensively. The
impact is an overall slowing in the economy.
G
N
I
N
R
A
ƒ Deflated asset values – As prices drop, asset values ranging from real estate
holdings to retail inventory drop. Absent a similar drop in liabilities, the result is
a drop in corporate income and a possibl
possible balance sheet driven drop in owner’s
equity.
P
E
L
ƒ Loans on deflated assets are payable
in increasingly valuable dollars – In this
E
scenario, the asset value is
but the purchasing power of the dollar is
Gdropping,
rising. Imagine, for example,
that you owe $500,000 on a house that is now
A
worth $250,000 because
dropped si
since you took out the original loan.
Gbuy twoits value
N
You could literally
houses for the amount of the home loan. When a
E the asset value, the borrower is said to be “upside down” or
loan value exceeds
C
“underwater,” and there is increased likelihood of default on the depreciated
asset. FThis is, in fact, one factor that has led to the large numbers of defaults in
theO
real estate market.
Y
T
The
deflationary trend can clearly have some negative impacts on business and the
EReconomy. Although deflation is rare, ththere has been increasing evidence of a
O
R
P
24
deflationary trend in the U.S. economy.xxi Ominously, one of the last periods of
prolonged deflation was during the Great Depression. Japan also experienced deflation
during the “lost decade,” the period in the 90’s and the early part of this century when
economic growth was slow, and even negative.
The Global Financial Crisis and Business
THE GLOBAL ECONOMIC CRISIS AND
ORGANIZATIONAL AND HUMAN RESOURCES
MANAGEMENT
Boards and Senior Management in Turmoil as
Daily Landscape Shifts
The Global Economic Crisis has presented a broad range of challenges in organizational
and human resources management. Senior management is under significant pressure as
revenues and profits spiral downward. The pressures have been particularly intense in
the financial services industry where several large firms such as Bear Sterns and Lehman
Brothers have collapsed entirely, while others have been effectively brought under
government control. Oftentimes, a corporate financial crisis will encourage the board of
directors to become more engaged (activist) in overseeing management activities in
order to put the company back on track. Whereas the crisis would appear to empower
more activist boards of directors, in fact many board members are drawn from the ranks
of executives from other companies who are already overtaxed by crisis management in
their own companies. One result has been an exodus from board management positions
in the period following the economic collapse.xxii
G
N
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A
E
AG
LE
G
N
E
The Business C
Bonus Dilemma
F
O
Senior corporate executives are also dealing with pressures of how to reward good
employees in bad times. On the one hand, it seems unseemly to award large bonuses to
some employees while others are being laid of
off and, in the case of the financial services
industry, customer’s portfolios are being ravaged. On the other hand, the high
performing employees that are essential to seeing the company through bad times need
to be rewarded to prevent defections to rival companies. Among financial services
firms at least, the trend seems to be for senior executives to forego year-end bonuses
while paring back significantly on middle management and junior employee bonuses. xxiii
In some cases, such as when a financial services company has been sold off or seized by
the government, senior managers have been forced to forego huge bonus payouts. John
Thain the CEO of Merrill Lynch, for example, was recently forced to give up a year-end
bonus totaling as much as $10 million.xxiv
Y
T
R
PE
O
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P
Managing Through Times of Force Reduction
Another management challenge is managing during a time when labor forces are being
trimmed. Employees at companies often form close bonds with coworkers, and a
reduction in force (i.e. a layoff) usually negatively impacts morale among remaining
employees not only because their friends and coworkers are now jobless, but also
because the expectation is usually that the remaining workers will take on the work of
25
Impact of The Global Economic Crisis on Business
their former coworkers. Paradoxically, employees become even busier as economic
activity declines.
Union–Management Relationships—Combined
Falling Demand and Global Competition Weaken
Union Clout
While it is difficult to fully judge the impact of the crisis on labor union power,
especially in light of recent Democratic election victories (the Democrats typically are
supportive of the labor union movement), it would appear that the crisis will combine
with existing global competition to further weaken union bargaining power. On the one
hand, the recently successful union action against aircraft manufacturer Boeing took
place against a company with large backorders (preexisting orders) and limited
competition. On the other hand, big union employers, such as the automobile companies
Ford and General Motors, are suffering from declining orders and are struggling to
survive. The United Auto Workers (UAW) has offered concessions on retiree benefits
and benefits for laid off workers as part of the overall effort to save ailing U.S. auto
makers.xxv Unless a significant turnaround
around takes place, labor unions in many industries
will be poorly poised to demand wage or bene
benefit increases. With unemployment on the
rise and both corporate profits and state and federal tax revenues declining, it is a
difficult time for any organized labor group to demand more.
G
N
I
N
R
A
E
AG
LE
G
N
E
It is not just American labor unions that are under pressure. South Korean
semiconductor manufacturer Hy
Hynix recently indicated that their labor union had agreed
to a program of salary cuts and layoffs.xxvi Across the globe, labor unions are in retreat
from the mounting pressure of the economic downturn.
F
C
Markets
O in Turmoil and the
Y for Labor Flexibility
Case
P
T
R
E Labor flexibility also seems to be impacted by the combined global economic crisis and
O
R
P
global competition. Because unions often comprehensively negotiate job descriptions
and working conditions into their contracts, it becomes difficult for employers to rapidly
shift job assignments or product production to meet demand or respond to competition.
This is a factor that has hurt the U.S. automobile manufacturers. Toyota, a non-union
employer which has 13 plants in North America, has been quick to shift product
production, closing down plants that build the Tundra, a large vehicle with low demand,
and expanding production of the energy-efficient Prius. The unionized American
automobile companies have been far slower to respond to the changing dynamics of the
industry, especially the rapid rise of oil prices in the 2006–2008 period, and have been
left holding huge inventories of large, inefficient vehicles.
It appears, then, that management is in a good position to demand wage concessions and
more workplace flexibility in the next few years. These demands relate to individual
workers as well as organized labor. It is hard to demand a raise when unemployment is
high and your office mates have just been laid off. Pay raises are a key employee
motivator and a way for management to reward productivity and effort. We may well
26
The Global Financial Crisis and Business
see a shift to non-cash forms of reward and motivation such as days off, changes in work
environment, and other non-cash awards for well-performing employees.
THE GLOBAL ECONOMIC CRISIS AND MARKETING
Impact of Falling Wealth and Constrained
Credit—Collapse of the Luxury Market?
The crisis is impacting marketers in a number of ways. One of the most obvious is the
pressure felt by the luxury goods market, from high-end art to luxury handbags. Early
indications are that there has been a significant drop
op in these markets. One example is
the art market. For example, Art Basel, the huge annual Miami art show, saw a
significant drop in sales and attendance at the fall 2008 show in Miami.xxvii Art auctions
at Sotheby’s and Christie’s, New York’s twoo largest art auction houses, saw similar
results.xxviii Evidence is mounting that the luxury goods market in general is coming
under the same pressure.xxix The pressure on the luxury goods market is driven by two
factors:
G
N
I
N
R
A
LE
E
G
ƒ Much activity in the luxury market
A has been driven by easy credit and perceived
wealth, backed by the valueG
of homes. Numerous individuals and families used
this perceived (paper) wealth
N to leverage purchases of luxury goods and now find
their net worth fallingE
while their debts from pervious purchases remain high.
These consumers C
are being forced to cut consumption significantly to make ends
meet.
F
O
ƒ The truly rich have, in many cases, suffered truly rich losses. While it may seem
Y with a net worth of $15 million isn’t going to worry about buying a
that someone
T
new leather couch, that person may ssee themselves not as someone worth $15
R
million, but as someone who just lost $10 million, and their purchasing decisions
E
P may reflect that perception. Losses among the wealthy in the September–
P
RO
November 2008 period have been truly breathtaking. One of the world’s richest
men, Warren Buffet, for example, is reported to have lost as much as $13 billion
dollars in 2008 (don’t worry, he still has $48 billion left).xxx
Meanwhile, Wal-Mart Thrives
While Others Fight to Survive
While the luxury market scrambles to survive, down brand and more cost conscious
brands are holding their own. Wal-Mart, the dominant discount chain, reported
November sales beat expectationsxxxi while Hormel, the maker of Spam (an inexpensive
canned meat product) has had to expand production to meet growing demand. xxxii While
the casual dining industry in general has suffered, McDonald’s posted strong November
2008 sales. Of the 30 companies that make up the Dow Jones Industrial Average, only
Wal-Mart and McDonald’s have seen their stock increase over the last year.xxxiii
27
Impact of The Global Economic Crisis on Business
Economic Collapse Puts the
Brake on Pricing Flexibility
Driven by surging prices of raw materials, prices for many goods across the economy
grew at an alarming pace in 2007 and into 2008. The crisis has drastically cut demand,
and marketers can no longer afford to pass price increases on to consumers. Even
luxury goods marketers, usually resistant to price cuts, have reduced prices in recent
months to stimulate demand. While post-Thanksgiving holiday sales were up slightly in
2008 over 2007, much of that increase is thought to be driven by price discounting.
In the non-luxury market, other high-end retailers are feeling the price squeeze too.
Abercrombie & Fitch has resisted price reductions introduced by other retailers and has
seen same store sales (a year over year comparison
mparison of revenues from the same retail
location) drop drastically in the September–November 2008 time period.xxxiv
G
N
I Advertising
The Global Economic Crisis and
N
R Many traditional Super Bowl
The crisis has also taken its toll on advertising.
A
advertisers, for example, are rethinking whether
E they want to spend up to $3 million on a
30 second advertising slot at the same L
time they are laying off employees and cutting
E in general appear to have fallen steeply with
back on bonuses.
Advertising revenues
G
the market crash and the end of the 2008 election season.
A
G
N
E
C CRISIS—ACCOUNTING,
THE GLOBAL ECONOMIC
F
O
FINANCE, AND INVESTMENT
Y
T
Accounting Issues—Write Downs Impacting
R
PE Corporate Balance Sheets
O Outside of the banking industry, the crisis has the largest impact on accounting through
R
the impact on corporate asset holdings and the effect that has on the corporate balance
P
sheet and income statements. The asset holdings may be in the form of real estate held,
xxxv
xxxvi
such as buildings and land, raw materials or inventory, or investments, which may
include common stocks, bonds, or derivatives including real estate-based derivatives.
The fall in asset prices has an impact on a company when they are forced to revalue the
asset to reflect the amount it can be sold for in today’s market, called “mark-to-market.”
The accounting impact can be generalized into one of two forms. Which form the loss
takes can depend on how long the asset has been held:
ƒ Losses on assets reflected on the income statement.
ƒ Losses reflected on the balance sheet, including market adjustment to assets and
adjustments to retained earnings.
28
The Global Financial Crisis and Business
Either adjustment can be highly negative for the company involved, reflecting either a
drop in income or in the overall worth of the company.
Money and Banking
More than any other industry, the financial services industry has felt the impact of the
crisis. Over the course of 2008, several large financial services firms have failed
entirely, been forced to put themselves up for sale, or been rescued by the government,
often at the cost of their independence. Smaller bank failures have become a frequent
occurrence with the Federal Deposit Insurance Corporation (the government institution
that insures banks) listing 22 banks failing through November 2008. This compares to
three failures in 2007.xxxvii
G
N
I
The crisis has developed so rapidly, and the nature of the government rescue plan
changed so often, that the precise effect of the crisis on the banking industry is hard to
categorize from day to day. To date, the following are known impacts on the banking
industry:
N
R
A
LE
ƒ Government-insured deposit limits have been changed from $100,000 to $250,000
to prevent depression era-type runs on banks.
E
AG
ƒ A number of investment banks have gone out of business (e.g. Bear Sterns—
investment banks are institutions which help raise money for other companies
and for governments), others have been forced into acquisition (e.g. MerrillLynch), and the more stable members of the investment banking community have
shifted their charters to become bank holding companies (e.g. Goldman Saks) in
order to become eligible for government rescue programs. Independent
investment banks have virtua
virtually ceased to exist in the last six months of 2008.
Y
T
R
F
O
G
N
E
C
ƒ The discount rate for overnight loans from the Federal Reserve given to the most
credit-worthy banks has fallen from 4% at the beginning of 2008, to 1.25% at the
end of November 2008. When the discount rate drops, the cost of borrowing in
general falls, causing both companies an
and consumers to borrow more and spend
more. This causes the economy overall to expand (speed up). This recent sharp
decline in interest rates represents a massive attempt to inject liquidity (money
that can be used for investment and borrowing) into the U.S. economy.xxxviii
PE
O
R
P
In the past, the Federal Reserve (the nation’s central bank) has relied on three key tools
to control the money supply: the discount rate, bank reserve requirements, and open
market operations. Now the Federal Reserve has launched several new tools to inject
liquidity into financial markets and prop up threatened institutions including the
Commercial Paper Funding Facility, which helps fund the purchase of highly rated,
asset-backed commercial paper (a form of short term corporate debt), the Money Market
Investor Funding Facility, designed to help secure money market funds, and the Primary
Dealer Credit Facility which makes credit available to selected dealers in government
securities and stocks. The addition of these new tools significantly expands the weapons
at the government’s disposal in fighting the economic crisis.
29
Impact of The Global Economic Crisis on Business
Credit Remains Sluggish and
in Some Cases Frozen
Despite these unprecedented moves by the federal government, credit has remained tight
and lending sluggish. There are several explanations for these phenomena:
ƒ Banks are attempting to preserve capital to help the asset side of their balance
sheets and so are reluctant to make loans.
ƒ There is significant loss of faith in the system with mistrust of the credit
worthiness of borrowers, leading banks to withhold loans from all but the most
credit worthy.
ƒ Related to the above, credit rating agencies (essentially companies that rate the risk
of other companies and their debt) have been shown to have been widely
inaccurate in some of their risk ratings over the past several years. Companies
rely on the credit rating agencies to guide them in choosing between risky and
less risky debt investments and so to make sound investment choices. The failure
of the rating agencies to accurately
rately predict the risk of many investments, often
stemming from conflict of interest, was a primary driver of the current crisis.
Now, without trust in the rating system, financial institutions are reluctant to issue
or buy debt.
G
N
I
N
R
A
LE
E
G
ƒ Insurers such as AIG make
some of their money issuing insurance on financial
A
assets including debt
This insurance helps companies reduce the
Ginstruments.
risk of their investment
strategies and, along with attention to credit ratings, helps
N
companies toE
investment loses. At least that’s how it is supposed to work.
C avoid
Huge defaults
on debt from other companies have driven AIG to the brink of
bankruptcy,
F and only federal government assistance has saved it from collapse.
The
Opotential for a collapse of the debt insurance market has further spooked
lending institutions.
TY
RThe result is that even though the Federal Reserve has attempted to drive interest rates
E
P down, they have remained stubbornly high for various forms of credit encompassing
RO
P
business loans, automobile loans, home financing, and college loans. In some cases, and
especially for borrowers with low credit scores, these types of loans have been almost
impossible to find. Thus while the Federal Reserve has reduced the discount rate by
almost 3% over the course of 2008, home equity loans, for example, have actually
increased over the same period, from 6.25% to 6.5%.xxxix
Falling Bond Ratings Raise the Cost of Borrowing
The rating agencies, stung by their poor recent rating performance and also by the failing
financial welfare of many corporations, have lowered their ratings across a broad
spectrum of corporate debt. The cost of borrowing for a corporation is inversely related
to their bond ratings. As ratings get lower, the cost of borrowing gets higher. The best
possible rating is Aaa, and corporate debt with this rating will have the lowest interest
and thus the lowest cost of borrowing. When a rating drops to Aa, A, or even Baa,
borrowing costs go up. The ratings agencies in late 2008 have been lowering corporate
30
The Global Financial Crisis and Business
debt ratings, and this is another factor that is driving the real cost of borrowing up, in
this case for corporations, at a time when the Federal Reserve-target rates are dropping.
Will My Bank Survive—The Corporate and
Consumer Perspective
Bank struggles have led both corporations and consumers to ask themselves whether
their bank will survive. Corporations worry that institutions that they depend on for
financing and financial advice will disappear, thus affecting their ability to operate.
Consumers worry that the money they have on deposit will be lost in the event that their
bank goes under. In some cases, this has led to a “run on the bank” in which depositors
withdraw their money in anticipation of the bank collapse. For example, in the eight
days after September 15, 2008, and immediately before it was seized and sold off by the
government, depositors withdrew over $16 billion from Washington Mutual.xl Such a run
becomes a self-fulfilling prophecy, leading to the very bank collapse that depositors fear.
G
N
I
N
R
A
For typical household, a bank collapse will have no long-term financial impact as
deposits are insured up to $250,000 as of October 2008 (note that the amount insured
falls back to $100,000, the original insured deposit amount before th
the crisis, at the end
of 2009). Nonetheless, even the temporary
temporary inability to access funds may be a problem
for households. Perhaps as troubling, for both consumers and business, is the
withdrawal of lines of credit and other sources of financing by a bank which is either in
financial trouble or has been newly acquired by another bank. While the federal
government insures many deposits, nobody assures that loans will be available. The
collapse of a bank may terminate relationships that are vital to both household and
corporate welfare.
E
AG
LE
G
N
E
C
F
The “Bailout”—What
Is It (Today) and Is It
O
Working?
Y
T
R
E
The “bailout,” officially named the Emergency Economic Stabilization Act of 2008, has
gone through a number of changes in the short time between enactment in early October
2008 and the end of the year. The overall purpose of the act is to ease tightness in credit
markets, which had been threatened by the collapse of Lehman Brothers and the near
failure of AIG in mid-September 2008. The original intention of the act was to provide
funding for the purchase of “toxic” mortgage-based assets from financial institutions,
thus eliminating these bad assets from balance sheets. This Troubled Asset Relief
Program (TARP) quickly proved to be unmanageable.
P
P
RO
In the two months since enactment of the act, the broad authority granted to the
Secretary of the Treasury has been used to shift the focus from the TARP to programs
that include loans to securities dealers, additional aid to troubled insurer AIG, direct
injection of capital into banking institutions, federal backing of mortgage-backed
securities, and support for the consumer loan market. As of the end of November 2008,
total government expenditures on these rescue operations were estimated to be over $3.5
trillion dollars.xli
31
Impact of The Global Economic Crisis on Business
Whether the act is working was still in question as of early December 2008. In the
previous week, there was some evidence that credit markets had began to thaw
slightly.xlii Nonetheless, markets remained volatile as evidenced by continued dramatic
swings in the Dow Jones Industrial Average.
Corporate Finance in the Current Environment—
The Potential for Raising Capital
The crisis has had significant impact on the ability of companies to finance operations:
ƒ Equity financing (money raised through the sale of stock) – The ability to raise
equity has virtually disappeared in the second half of 2008, with only one initial
public offering in the period July–October. Existing public companies often issue
new stock to raise capital, but the current environment makes such financing
difficult because of the depressed prices of stock and the threat that selling
additional shares will further depress
ess share prices (referred to as dilution).
G
N
I
N
R
A
ƒ Cost and sources of debt financing – As earlier stated, debt financing (financing
through borrowing) gets more expensive as a company’s debt rating is reduced
(basically the corporate equivalent of a consumer credit score). Companies have
also found that there are fewer creditors willing to buy debt as the “flight to
safety” causes investors to prefer “riskless” government bonds.
E
AG
O
R
P
G
N
E
ƒ Issues of cash flow financing through trade credit – One traditional source of
short-term company financing is trade credit. Trade credit occurs when a
supplier allows a buyer to purchase “on account,” often paying at a date 30–90
days later. For example, Black & Decker might ship 10,000 cordless drills to
Home Depot for a holiday promotion. Home Depot doesn’t pay immediately for
the drills, but instead reimburses Black & D
Decker 30 to 90 days later. In this
case, Black & Decker has extended trade credit to Home Depot. As cash flow
tightens, some companies are refusing to grant trade credit or charging higher
interest on bills past due. At the other end, corporate customers are slowing
payments, often paying bills in 60 to 90 days when they might have earlier paid
in 30 days. For the company, they now have more money going out and less
money coming in, putting additional pressure on their finances.
Y
T
R
PE
LE
F
O
C
ƒ Stability of money flows across borders - Companies doing business globally want
predictability in their cash flows. The predictability can come from two sources:
o
Stable exchange rates.
o
Hedging strategies such as the purchase of forward contracts on foreign
exchange. These contracts essentially let the company lock in an exchange
rate for a future date so that they can predict their cash flow.
Unfortunately, both these tools have come under pressure due to the crisis with large
exchange rate movements and a freezing up of the forward market.
32
The Global Financial Crisis and Business
CONCLUSION—A NEW WORLD FOR BUSINESS
The global economic crisis threatens to change much about the way we do business. In
the end, it may even shift views about capitalism and more socialist economic systems.
Events have played out so rapidly that it is difficult to predict exactly where things will
stand even six months from now. Since the beginning of 2008, we have witnessed
unparalleled shifts in the global economic world. Resource rich countries such as Russia
that were only recently strutting their wealth are now reeling from the shock of declining
prices on oil and other raw materials. The high-growth economies of China and India
are facing significant unrest for the first time in decades as world demand for their goods
slows and their economies falter. Institutions such as the IMF are playing an expanded
and increasingly critical role in propping up foreign economies.
G
N
I
In the U.S., the titans of Wall Street have
ve fallen one by one: Bear Sterns, Lehman
Brothers, Merrill Lynch, AIG, and Washington Mutual, all firms once thought to be too
big to fail, have all disappeared or been forced to accept a government rescue. Other
large investment banks such as Goldman Sachs and Morgan Stanley have converted into
bank holding companies in order to qualify for government aid. The big three auto
makers, once the very symbol of American industrial might, have gone from ram tough
to puppy dog humble as they seek rescue money from Congress.
N
R
A
E
AG
LE
If the damage were limited to Wall Street and Detroit, we could count ourselves lucky.
But the economic crisis has forced under smaller banks across the county, emptied out
retirement funds, and reduced college endowments. For business big and small, the
collapse of the credit market has meant that they have less money to build things and
their customers have less money to buy the things they build. All this has led to a severe
drop in business activity right at the holiday season time when it is usually the strongest.
For many workers, this means that instead of being handed year-end bonus checks, they
are being handed pink slips.
Y
T
R
F
O
G
N
E
C
Times of economic pain are not without their benefits. In the long run, banks and
investment banks will go back to doing what they do best, raising money and investing it
for the future. Americans will learn to save more and invest more wisely. And weaker
businesses and industries will make way fo
for stronger and more productive rivals.
Government regulation will become sounder. As much as business will be changed, the
fundamental practice of running a strong business will remain. The formula is tried and
true: build great products, treat customers and employees well, manage finances
carefully and operations smartly. All these will work as well in the future as they did in
the past. Added to that will likely be a new sense of business conservatism that will
serve businesses and their customers well.
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Impact of The Global Economic Crisis on Business
Footnotes
i
“Yuan’s Fall Watched Ahead of U.S. – China Summit,” The Wall Street Journal, December 2, 2008: A12.
ii
www.goldprice.org/gold-price-history.html
iii
See for example, Board of Governors, U.S. Federal Reserve, www.federalreserve.gov/releases/bulletin/1108assets.htm#fn1.
iv
“Currency Fall Reflects Ukraine’s Woes,” The Wall Street Journal, December 4, 2008.
v
“Strong Dollar May Take Bite Out of Profits,” The Wall Street Journal, December 2, 2008.
vi
“U.S. Doesn’t Need IMF’s Cash, but Does Need Its Help” The Wall Street Journal, October 6, 2008.
vii
“Healthy Countries to Receive IMF Loans,” The International Herald Tribune, October 30, 2008.
viii
U.S. Census Bureau, http://www.census.gov/foreign-trade/balance/c5700.html.
ix
Katel, Peter, "Emerging China," CQ Researcher 15.40 (2005): 957-980.
x
CIA World Factbook, www.cia.gov/library/publications/the-world-factbook/.
xi
“China
Quarterly
Update
–
December
G
N
I
RN
2008,”
The
World
Bank,
web.worldbank.org/WBSITE/EXTERNAL/COUNTRIES/EASTASIAPACIFICEXT/CHINAEXTN/0,,contentMDK:219870
SIAPACIFICEXT/CHINAEXTN/0,,contentMDK:219870
33~pagePK:1497618~piPK:217854~theSitePK:318950,00.html.
xii
A
E
L
Andrew Batson, "World News: Beijing Sketches Outlines of Stimulus
Stimulus Plan—Central Government to Fund a Quarter of $586
E
Billion Package, Rely on Local Authorities, Private Sector," Wall Street Journal, November 15, 2008, Eastern edition: A.5.
xiii
xiv
AG
“China Fears Restive Migrants As Jobs Disappear in Cities,” The Wall Street Journal, December 2, 2008: A1.
“Bush
urges
foreign
nations
to
support
free
trade,”
CNNMoney.com,
G
N
E
money.cnn.com/2008/11/22/news/international/Bush_Peru.ap/index.htm?postversion=2008112210.
money.cnn.com/2008/11/22/news/international/Bush_Peru.ap/index.htm?postversion=2008112210.
xv
Jessica E. Vascellaro, Scott Morrison, "Google Gears Down for Tougher Times," The Wall Street Journal, December
3, 2008, Eastern edition: A.1.
C
xvi
www.comscore.com/press/release.asp?press=2607.
xvii
Office of the President, http://frw
http://frwebgate.access.gpo.gov/cgi-bin/multidb.cgi.
xviii
F
O
Bureau of Labor Statistics, http://www.bls.gov/cps/cpsatabs.htm.
Y
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xix
“Bank Lending During the Financial Crisis of 2008,” Vict
Victoria Ivashina, Harvard Business School, David Scharfstein,
xx
“Escalation of Layoff Protest Poses Risks for Bank of America,” The Wall Street Journal, December 9, 2008: B8.
xxi
See for example “The Fed is Out of Ammunition,” The Wall Street Journal, November 24, 2008: A19.
xxii
Joann S. Lublin, "As Firms Flounder, Directors Quit—Departing Board Members Cite Too-Frequent Meetings and
Harvard Business School and NBER, November 5, 2008.
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xxiii
Conference Calls at AIG, Ford, Others, " The Wall Street Journal, November 21, 2008, Eastern edition: B.1.
Ann Davis, "Top Traders Still Expect the Cash—Wall Street CEOs Are Giving Up Pay, but Hotshots Are Another
Story, " The Wall Street Journal, November 19, 2008, Eastern edition: C.1.
xxiv
“Thain and Mack Lose ’08 Bonuses,” The Wall Street Journal, December 9, 2008: C1.
xxv
“UAW Gives Concessions to Big Three,” The Wall Street Journal, December 4, 2008: B1.
xxvi
“Hynix to Cut Top Salaries, Plans Layoffs,” The Wall Street Journal, December 8, 2008: B7.
xxvii
Kelly Crow, "Adviser—Art / Art Basel Miami Beach: All's Not Fair in Miami—The slumping market drains the energy out
of the city's annual art bash," The Wall Street Journal, December 5, 2008, Eastern Edition: W.2.
xxviii
Kelly Crow, "Call This One 'Crisis With a Pipe'—Financial Downturn Finally Leaves an Impression on the Art Market," The
Wall Street Journal, November 15, 2008, Eastern Edition: B.1.
xxix
See for example Rachel Dodes, Christina Passariello, "In Rare Move, Luxury-Goods Makers Trim Their Prices in U.S.," The
Wall Street Journal, November 14, 2008, Eastern Edition: B.1.
34
xxx
“Super Rich See Wealth Evaporate in Credit Crunch,” The Otago Daily Times (New Zealand), November 3, 2008.
xxxi
Wal-Mart Investor Relations, http://walmartstores.com/Investors/7602.aspx.
The Global Financial Crisis and Business
xxxii
D. A. Kolodenko, "Spam a Lot, " Syracuse New Times, [Syracuse], September 24, 2008: 7-8.
xxxiii
“McDonald’s Sales Keep Growing,” The Wall Street Journal, December 9, 2008: B3.
xxxiv
“Abercrombie Fights Discount Tide,” The Wall Street Journal, December 8, 2008: B1.
xxxv
Suzanne Vranica, “Tough Times Complicate the Case for Buying Super Bowl Ads” The Wall Street Journal, November 11,
xxxvi
David Gaffen, MarketBeat / Market Insight from WSJ.com, The Wall Street Journal, November 5, 2008, Eastern
xxxvii
See Federal Deposit Insurance Corporation list of failed banks, http://www.fdic.gov/bank/individual/failed/banklist.html.
2008, Eastern Edition: B.1.
Edition: C.6.
xxxviii See the Federal Reserve Board, www.frbdiscountwindow.org/historicalrates.cfm?hdrID=20&dtlID.
xxxix
HSN Associates Financial Publishers, www.hsh.com/natmo2008.html.
xl
“Money & Co.” Los Angeles Times, September 25, 2008, http://latimesblogs.latimes.com/money_co/2008/09/just-as-with-
xli
“A Long Tab,” The Wall Street Journal, November 26, 2008.
xlii
“In Europe, a Credit Market Thaws a Bit,” The Wall Street Journal, December 1, 2008: C2.
in.html.
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