AGNOSCERE. An open house to global citizens

Post No. 20. 2008 Financial Crisis

It was the worst economic disaster since the Great Depression of 1929. It occurred despite Federal Reserve and Treasury Department efforts to prevent it.

It led to the Great Recession. That’s when housing prices fell 31.8%, more than during the Depression. Two years after the recession ended, unemployment was still above 9%. That’s not counting discouraged workers who had given up looking for work.

The first sign that the economy was in trouble occurred in 2006. That’s when housing prices started to fall. At first, realtors applauded. They thought the overheated housing market would return to a more sustainable level. They didn’t realize there were too many homeowners with questionable credit. Banks had allowed people to take out loans for 100 percent or more of the value of their new homes. Many blamed the Community Reinvestment Act [Act that encourages bank lending to low-and moderate-income neighborhoods. Enacted in 1977, it sought to eliminate bank “redlining” [practice of using a red line on a map to delineate the area where financial institutions would not invest] of poor neighborhoods. In redlining, neighborhoods were designated as not good for investment. As a result, banks would not approve mortgages for anyone who lived in those areas. It didn’t matter how good the applicant’s individual finances or credit was. Some experts argued that these areas were initially established by the Federal Housing Administration, which guaranteed the loans.

The Community Reinvestment Act pushed banks to make investments in subprime areas, but that wasn’t the underlying cause.

The Gramm-Rudman Act was the real villain. It allowed banks to engage in trading profitable derivatives [financial contract that derives its value from an underlying asset (term used in derivatives trading, such as with options. A derivative is a financial instrument with a price that is based on (that is, derived from) a different asset. The underlying asset is the financial instrument (such as stock, futures, a commodity, a currency or an index) on which a derivatives price is based) that they sold to investors. These mortgage-backed securities (MBS is a type of asset-backed security that is secured by a mortgage or collection of mortgages) needed home loans as collateral. The derivatives created an insatiable demand for more and more mortgages.

The Federal Reserve believed the subprime mortgage crisis (this occurred when banks sold too many mortgages to feed the demand for mortgage-backed securities. When home prices fell in 2006, it triggered defaults. The risk spread into mutual funds, pension funds and corporations who owned these derivatives. It led to the 2007 banking crisis, the 2008 financial crisis and the worst recession since the Great Depression.

Fed officials didn’t know how far the damage would spread. They didn’t understand the actual causes of the subprime mortgage crisis until later.

Hedge funds and other financial institutions around the world owned the mortgage-backed securities. The securities were also in mutual funds, corporate assets, and pension funds.

The banks had chopped up the original mortgages and resold them in tranches. That made the derivatives impossible to price.

Why did stodgy pension funds buy such risky assets? They thought an insurance product called credit default swaps (contract that guarantees against bond defaults. They work like an insurance policy.) protected them. A traditional insurance company known as AIG sold these swaps. When the derivatives lost value, AIG didn’t have enough cash flow to honor all the swaps.

Banks panicked when they realized they would have to absorb the losses. They stopped lending to each other. They didn’t want other banks giving them worthless mortgages as collateral. No one wanted to get stuck holding the bag. As a result, interbank borrowing costs (known as Libor [ interest rate that banks charge each other for overnight, one month, three-month, six-months and one-year loans. It’s the benchmark for bank rates all over the world. It is the acronym for London InterBank Offered Rate] rose. This mistrust within the banking community was the primary cause of the 2008 financial crisis.

In 2007, the Federal Reserve began pumping liquidity into the banking system via the Term Auction Facility (a temporary program managed by the United States Federal Reserve designed to “address elevated pressures in short-term funding markets.”). Looking back, it’s hard to see how they missed the early clues in 2007.

The Fed’s actions weren’t enough. In March 2008, investors went after investment bank Bear Stearns. Rumor circulated that it had too many of the toxic assets ( popular term for certain financial assets whose value had fallen significantly and for which there is no longer an functioning market, so that such assets cannot be sold at a price satisfactory to the holder.). Bear approached JP Morgan Chases to bail it out. The Fed had to sweeten the deal with a $30 billion guarantee.

Wall Street thought the panic was over.

Instead, the situation deteriorated throughout the summer of 2008. Congress authorized th Treasury Department to bail out mortgage companies Fannie Mae and Freddie Mac. The Fed used $85 billion to bail out AIG. In October, this rose to $150 billion.

On September 19, 2008, the crisis created a run on ultra-safe money market funds. That’s were most firms put any excess cash they might have accrued by the end of the day. They can earn a little interest on it overnight. Banks use those funds to make short term loans. During the run, companies moved a record $140 billion out of their money market accounts into even safer Treasury bonds. If these accounts went bankrupt, business activities and the economy would grind to a halt.

Treasury Secretary Henry Paulson conferred with Fed Chair Ben Bernanke.

They submitted to Congress a $700 billion bailout package. Their fast response convinced businesses to keep their money in the money market accounts.

Republicans blocked the bill for two weeks. They didn’t want to bail out banks. They didn’t approve the bill until global stock markets almost collapsed. It was one of the 33 critical events in the 2008 financial crisis timeline.

But the bailout package never cost the taxpayer the full $700 billion. The Treasury Department only used $350 billion to buy bank and automotive company stocks when the prices were low. By 2010, banks had paid back $194 billion into the TARP fund.

The other $350 billion was for President Obama, who never used it. Instead, he launched the $787 billion Economic Stimulus package. That put money directly into the economy instead of the bank. It was enough to end the financial crisis in July 2009.

The government must step in to regulate. Congress passed the Dodd-Frank Wall Street Reform Act [This Act was signed into United States Federal Law by President Barack Obama onJuly 21, 2010. Passed as a response to the financial crisis of 2007-2008, it brought the most significant changes to financial regulation in the United States since the regulatory reform that followed the Great Depression. It made changes in the American financial regulatory environment that affected all federal financial regulatory agencies and almost every part of the nation’s financial services industry.) to prevent banks from taking on too much risk. It allows the Fed to reduce bank size for those that become “to big to fail.” ( extracted from The Balance)

But it left many of the measures up to federal regulators to sort out the details. Meanwhile, banks keep getting bigger and are pushing to get rid of even this regulation. The financial crisis of 20088 proved that banks could not regulate themselves. Without government oversight like Dodd-Frank, they could create another global crisis.

References

Three weeks that changed the world

https://www.theguardian.com/business/2008/dec/28/markets-credit-crunch-banking-2008

The 2008 Financial Crisis: Crash Course Economics #12. Time: 11:24:

https://www.youtube.com/watch?v=GPOv72Awo68&t=169s

The Financial Crisis of 2008. Time: 7:47:

https://www.youtube.com/watch?v=3eGztaZZy7k

Financial Crisis 2008. Time: 5:18:

https://www.youtube.com/watch?v=RNrVST2LgKY

The Causes and Effects of the 2008 Financial Crisis. Time: 11:10:

https://www.youtube.com/watch?v=N9YLta5Tr2A

CrashCourse- The Financial Crisis: Crash Course Economics ( Financial Crash). Time: 42:04: