The 2008 Financial Crisis

Approximately every 50 to 80 years the world experiences an economic meltdown of catastrophic proportions. The one most people think of is the “Great Depression” of the 1930s. But the more recent example is the 2008 Financial Crisis. This crisis had the potential to be as bad as the Great Depression but Government action i.e. Unemployment Insurance and massive liquidity pumping was able to mitigate the effects somewhat. However, even with those actions, U-3 unemployment reached 10.6% and U-6 unemployment which is more like the measurement used in the 1930s reached 18%.

What Caused the 2008 Crisis?

The 2008 crisis is the culmination of a series of missteps and failed legislation. Traditionally, lenders would only lend to “qualified buyers” but Congress decided that it would be a good thing to encourage homeownership so they instituted a series of changes to regulations allowing banks to shift some of the risk from the lender to the Federal Government. Specifically, to the three housing agencies Fannie Mae, Freddie Mac, and Ginnie Mae.

Fannie Mae (FNMA – Federal National Mortgage Association)
Freddie Mac (FHLMC – Federal Home Loan Mortgage Corporation)
Ginnie Mae (GNMA – Government National Mortgage Association)

These three agencies allowed banks (and mortgage brokers) to create loans pretty much regardless of the borrower’s ability to repay and then pass off the loan to one of these agencies which then bundled them into various large bundles and sold them to investors, both foreign and domestic.

To make matters worse, risk rating agencies gave these “mortgage-backed securities” high safety ratings i.e. AAA ratings. This was partially because housing prices were going up, so the risk was considered to be minimal because “the house could always be sold for more than the mortgage due to rising prices”. Another reason the risk was considered minimal was because most people were unlikely to default because they were a “good credit risk” and adverse to losing their home. And finally, there were thousands of mortgages in the bundle so even if a few defaulted it was only a small percentage.

Increased Demand for Mortgage-Backed Securities

Since these securities paid better returns the demand for them increased. So, lenders did their best to create more of them. To do so they had to lower their lending standards. They began lending to anyone with a pulse even if there was no way they could actually repay the loans. These were called “subprime mortgages”. But even then there weren’t enough borrowers so lenders got even more aggressive in their lending, trying rope in the unsuspecting with “predatory lending practices” which included variable rates that started out great but quickly became unaffordable. The new lax lending requirements and low-interest rates drove housing prices higher, which only made mortgage-backed securities seem like an even better investment.

Collateralized Debt Obligations (CDOs)

In addition to regular mortgage-backed securities investment firms and big banks “sliced and diced” these bundles of mortgages into “derivatives” which created the appearance of even less risk than there actually was. A CDO is a specialized financial product backed by a pool of loans. CDO sales rose almost tenfold from $30 billion in 2003 to $225 billion in 2006. In an effort to further limit and divide risk financial institutions created Credit Default Swaps which is a derivative of the mortgage bundles and CDOs. Basically, it was a form of insurance against default. This transferred the risk of default to someone else.

The Housing Crash

When housing prices began to fall and the whole “house of cards” excuse the pun, began to fall. As prices declined people who had borrowed 100% of their house value realized that their mortgage was now more than their house was worth and their expectation of being bailed out by rising house prices was now a “pipe dream’. So, the less credit-worthy began defaulting and this drove housing prices down further. This snowballed into further price declines and more defaults.

Unfortunately, issuers (like AIG) of Credit Default Swaps underestimated the sheer magnitude of the risk they were taking on and as housing prices crashed and more people defaulted, these insurers ended up unable to cover all of their losses causing them to declare bankruptcy. The problem snowballed to Lehman Brothers and Bear Stearns and threatened to take down the entire banking industry. At that point, the government stepped in to halt the chain reaction.

Economic Slowdown

As the housing crisis snowballed the overall economy began slowing down as well causing people to lose their jobs and more people realized that they could no longer make their mortgage payments, thus causing more defaults, etc. Panic set in, stock markets crashed and people feared that the banking system would collapse.

Government Actions

In an effort to stem the tide of the crash the government stepped in and bailed out the biggest banks. The Federal Reserve offered to make emergency loans to banks shoring up those who were fundamentally sound but simply suffering from the overall panic. They eventually ended up spending $250 billion bailing out banks, AIG and even automakers.

The U.S. Treasury also conducted “stress tests” on the largest banks publishing the results, in an effort to alleviate popular fear about the safety of the banks. Congress also passed a huge stimulus package of over $800 Billion in January 2009, in an effort to pump more liquidity into the economy.

In 2010, Congress passed the Dodd-Frank Law in an effort to increase transparency and regulate how much risk banks can take. It set up a consumer protection bureau to reduce predatory lending practices. It also made the trading of CDOs and derivatives more transparent. It also made it possible for banks to fail in a more controlled predictable manner thus further eliminating uncertainty.

The government failed to properly regulate and supervise the financial system and they created “perverse incentives” that encouraged lending to high-risk individuals with the expectation that everyone could pass the risk on to someone else.

Key Terms:

1) Default – when a debtor is unable to meet the legal obligation of debt repayment.

2). Mortgage back securities are created when large financial institutions bundle mortgages and sell them as securities i.e. bonds.

3) Subprime mortgage – a loan granted to individuals with poor credit history.

4) Credit default swaps- a derivative of mortgage-backed securities intended to “insure” against default.

5) Perverse incentive – when a policy ends up having a negative effect opposite of what is intended.

5) Moral hazard – when one person takes on more risk because someone else bears the burden of that risk.

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