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How Did the 2008 Crash Happen? What Regulations Came Out of It?

Info: 2067 words (8 pages) Essay
Published: 23rd Mar 2021 in Finance

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A lot of people remember 2008 as a year with many different events: the premier of AMC’s Breaking Bad, Fidel Castro retired from being the president of Cuba, or even the start of Benedict XVI’s papal journey. But the 2008 financial crisis is the most important memory of all. Ben Bernanke, the Chairman of the Federal Reserve at the time, said that it could have resulted in a 1930-style global and financial economic meltdown with catastrophic implications. (Bernanke, 2009) But what happened? How could such an event happen? Why aren’t we all huddled around trash bins set on fire, forming a plot to steal necessities from other crews in the wasteland?

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Mortgages

In order to explain what happened throughout the 2000s, it would initially require an understanding of mortgages and the housing market. As you may already know, when one decides to purchase real estate, both primary and investment properties, that person will borrow hundreds of thousands of dollars from a bank or financial institution of some sort in order to complete the purchase. The purchaser of the property will get the home and the bank will hold a piece of paper, called a mortgage. Every month, the borrower and owner of the property is obligated to pay the lender some principal borrowed plus interest (the bank’s return for lending the money) to whomever holds that piece of paper. If the borrower decides to stop paying theses monthly installments, the loan will go into default, commencing the foreclosure process. By the end of the foreclosure, the residents must vacate and the holder of the paper gets to keep the house. I say “whomever holds the paper,” rather than “the bank,” because the original lender will, more often than not, sell that mortgage to a third party.

Prior to the 2000s, traditionally, it was difficult and almost impossible to borrow money from a bank and purchase a home if you had bad credit or didn’t have a steady, provable stream of income. Lenders simply did not want to take gamble on whether lenders would default on your loan, causing the bank to lose money. But we started to see a change in the 2000s. Come early 2000s, investors around the world looking for a low risk and high return investment, shifted astronomical amounts of money into the U.S. housing market. The thought behind this investment was that investors can get a greater return on the interest rates home owners were paying than they could have earned had their money been invested in other vehicles. The interest rates mortgages were paying were higher than U.S Treasury Bonds.

Mortgage Backed Securities

However, it does not make sense for wealthy and strong investors to want to purchase single mortgages at a time; the work associated in single mortgage purchases isn’t justified by the rate or return. Conversely, these investors purchased an investment vehicle known as Mortgage Back Security, or MBS for short. An MBS is when large investment banks and large financial institutions move traditional mortgages into securities. Simply put, the banks purchase thousands of mortgages, bundle them together, wrap them in a nice bow, and sell them as shares to investors, like they do with stocks in mutual funds.

And said investors could not wait to purchase more of them because the Mortgage Backed Securities were offering higher rates of return than they can get through other investment vehicles and they looked to offer very low levels of risk. It made sense, in theory. First off, homes were selling at steadily increased prices as the values continued to increase. From the mindset of a lender, they thought “worst case scenario, the borrower can default on the mortgage and we can always resell the same home for more money; win-win.”

Credit Ratings

At the same time, the most reputable credit rating agencies (the companies who determine whether or not a company is stable or not), like Standard and Poor’s and Moody’s were telling investors (through the ratings they provided) these were innocent investments. They presented a lot of the MBSs with AAA ratings – the best rating that can be issued. Receiving a AAA credit rating indicates as close to risk free as possible. Sure, one can say that back when mortgages were only for good borrowers with good credit, mortgage debt was a good investment.

Regardless of the credit rating issued, investors were eager to trade more and more of these securities – they loved them. The basic economic theory of supply and demand arises; there can only be so many mortgages available for banks to bundle before the market runs out of mortgages. To create more securities, more people would need to purchase more homes, utilizing banks for more mortgages. This is when lenders loosened their standards, allowing people with low income and subpar credit scores the ability to purchase homes they may or may not have been able to afford. These risky mortgages are referred to as “sub-prime mortgages.” Eventually, some banks and financial institutions started using unethical predatory lending practices because they could not keep up with the demand for MBSs. These practices meant banks were making loans without verifying income, offering Adjustable Rate Mortgages with payments people could initially afford but, with time, interest payments inflating beyond repayment.

Collateralized Debt Obligations

These new sub-prime lending practices were new to the industry and had never been used before. This is important because credit agencies were referring to historical data when rating these new mortgages. It later showed that it didn’t deem very relevant to the sub-prime industry. Claiming these new sub-prime MBSs were a safe bet, they were anything but safe. In fact, as time went on, the mortgage back securities being sold were becoming less and less safe. Unbeknownst to them, investors trusted the rating agencies and kept buying more and more and banks created an even riskier investment, collateralized debt obligation, or CDO. Again, like Mortgage Backed Securities, these CDOs were given some of high credit ratings. Afterall, if the consumer defaulted, the bank would just get back the home and sell it again. Right?

Wrong. To make the matter even worse, America was sitting in amidst a housing bubble. A “bubble” is a rapid price increase of any item driven by irrational decisions. (Pettinger, 2017) Since bubbles burst, this economic “bubble” was not dissimilar – people were no longer able to pay for their posh homes nor keep up with the expanding mortgage payments. (CrashCourse, 2015) People started defaulting, putting more homes back on the market for sale. This time, however, there weren’t enough buyers in the market. Simply put, the supply of homes was up, the demand was low, and the value of these homes started collapsing. Some borrowers were even “upside-down,” a term used to describe when an asset is leveraged more than the asset is worth.

As this was happening, the bigger financial institutions became aware of what was going on and stopped procurement of these subprime mortgages and subprime lenders were left with the bad loans they underwrote. Come 2007, some of the world’s big lenders and banks declared bankruptcy because of the bad decisions they made as a firm. The problem spread; the big investors, who had transferred large sums of money into these Mortgage Backed Securities and CDOs, started losing money on their investments as a biproduct.

As a result, big investors, like Lehman Brothers declared bankruptcy. Others were forced into mergers, or needed to be bailed out by the federal government. No one knew exactly how bad the balance sheets at some of these financial institutions really were; these complicated, unregulated assets made it hard to tell. Panic set in. Trading and the credit markets froze. The stock market crashed. And the United States economy suddenly found itself in a disastrous recession.

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Government Assistance

So, what did the government do? Well, it did a lot. The Federal Reserve, although not a government entity stepped in and offered to maker emergency loans to banks. The idea was to prevent fundamentally sound banks from collapsing just because their lenders were panicking. The government enacted a program called TARP, Troubled Assets Relief Program, which the public calls “The Bank Bailout.”

This initially earmarked $700 billion to shore up the banks. It actually ended up spending $250 billion bailing out the banks, and was later expanded to help auto makers, AIG, and homeowners. In combination with lending by The Fed, this helped stop the cascade of panic in the financial system.

The treasury also conducted stress tests on the larges Wall Street banks. The government sent accountants swarmed over bank balance sheets and publicly announced which ones were sound and which ones needed to raise more money. This eliminated some of the uncertainties that had paralyzed lending among institutions.

Congress also passed a stimulus package in January of 2009. This pumped over $800 billion into the economy, through new spending and tax cuts. This helped slow the free fall of spending, output, and employment. All of which were historically down.

Regulation

In 2010, Congress passed for the first time in history a financial reform that changed every sector of the financial industry, call the Dodd-Frank law. It aimed to take on corruption by enabling steps to increase transparency and avoid banks from plaguing themselves with so much risk they jeopardize the entire world’s economy. More importantly, Dodd-Frank set up a consumer protection bureau to reduce predatory lending. (CrashCourse, 2015) It mandated financial derivatives to be traded in market platforms that all desired participants can observe and study. Also, it put parameters in motion for large banks to fail in a controlled, predictable manner. But there is no consensus on whether this regulation is enough to prevent future crises.

When something terrible happens, people naturally look for someone to blame. In the case of the 2008 financial crisis, no one had to look very far because the blame and the pain was spread throughout the US economy. The government failed to regulate and supervise the financial system. To quote the bi-partisan, Financial Crisis Inquiry Commission report, “the sentries were not at their posts, in no small part due to the widely accepted faith in the self-correcting nature of the markets, and the ability of financial institutions to effectively police themselves.” (The Financial Crisis Inquiry Commission, 2011) The report placed some of the blame on years of deregulation in the financial industry and blamed regulators for not doing more.

The financial industry failed. Everyone in the system was borrowing too much money and taking too much risk, from the big financial institutions, to the individual borrowers. The institutions were taking on huge debt loads to invest in risky assets. Conversely, huge numbers of home owners were taking on mortgages they couldn’t afford. But the thing to remember about this massive systemic failure, is that it happened in a system made up of humans, with human failing. Some didn’t understand what was happening. Some willfully ignored the problems. And some were simply unethical, motivated by the massive amounts of money involved. The last word should be given to the Financial Crisis Inquiry Commission; in rephrasing Shakespeare, they wrote, “The fault lies not in the stars, but in us.” (The Financial Crisis Inquiry Commission, 2011)

References

  • Bernanke, B. (2009). American Internation Group.
  • CrashCourse. (2015, October 21). The 2008 Financial Crisis: Crash Course Economics #12. Retrieved from YouTube: https://youtu.be/GPOv72Awo68
  • Pettinger, T. (2017, April 29). Different types of economic and financial bubbles. Retrieved from Economics Help: https://www.economicshelp.org/blog/7424/finance/different-types-of-economic-and-financial-bubbles/
  • The Financial Crisis Inquiry Commission. (2011). The Financial Crisis Inquiry Report. Washington, DC.

 

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