Financial Crisis of 2008-?

Origination of the Crisis

There is disagreement in the field of economics about the beginnings of the Financial Crisis of 2008-2009.  Some economists want to focus on the short term causes that preceded the crisis from 2006 to the fall of 2008.  Others want to go back decades and emphasize long term structural problems.  Problems with the repayment of subprime mortgages in the US triggered a tidal wave of concern about lending around the world in August 2007. Approximately 80% of U.S. mortgages issued in recent years to subprime borrowers were adjustable-rate mortgages. When U.S. house prices began to decline in 2006-07, refinancing became more difficult and as adjustable-rate mortgages began to reset at higher rates, mortgage delinquencies soared. Securities backed with subprime mortgages, widely held by financial firms, lost most of their value. The result has been a large decline in the capital of many banks and USA government sponsored enterprises, tightening credit around the world.

Consumers also felt a price squeeze: commodity prices rose rapidly in 2007 and the first six months of 2008, driven by demand from booming China and India, pushing up petrol, food and other basic costs. This surging inflation hindered distracted central banks and hindered them from cutting interest rates to help ease the credit crunch.  Fears were increased by the collapse of Bear Stearns in March 2008 but the financial crisis proper began in September with the collapse of Lehman Brothers.

Beginning with failures of large financial institutions in the United States, it rapidly evolved into a global credit crisis, deflation and sharp reductions in shipping resulting in a number of bank failures worldwide and declines in various stock indexes, and large reductions in the market value of equities (stock) and commodities worldwide.

Events began to converge in the fall of 2008.  Giant mortgage companies Fannie Mae and Freddie Mac collapsed. The event sent shockwaves through the economy as confidence in Wall Street began to evaporate. In September 2008, another investment bank, Lehman Brothers, was on the brink of collapse. There were calls to bail out the Wall Street giant. But Paulson was under intense political pressure from conservative Republicans in Washington to invoke moral hazard and let the company fail.

The field of economics is also to blame for the crisis.  The overconfidence of the economic profession in this period is exemplified by Robert Lucas’s 2003 presidential address to the American Economic Association, in which he declared that the “central problem of depression-prevention [has] been solved, for all practical purposes”.

Those heading up the Federal Reserve are also responsible. Ben Bernanke and his predecessor Alan Greenspan operated as virtual cheerleaders for rising debt levels, justifying every new debt instrument that the finance sector invented, and every new target for lending that it identified, as improving the functioning of markets and democratizing access to credit. At the 2007 peak, total debt in the US reached a record 5 times GDP (versus 3 times GDP in 1929), with most of it private debt of households and firms.

Credit ratings agencies played an important role, providing high ratings to assets that were very much riskier than indicated.

(The Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States (commissioned by the US Congress and President Obama) concluded that the crisis was both foreseeable and preventable. It blamed the ‘captains of finance’ (heads of the biggest banks) and the ‘public stewards’ (officials charged with regulating the banks) for the systemic breakdown in accountability and ethics that led to the crisis.

 

Government Reaction Under President Bush

On September 16th, 2008 the Fed and the Treasury met to decide what to do about AIG, the country’s largest insurer.  AIG had issued trillions of dollars worth of credit default swaps but it had no financial reserves to support a financial collapse.  Treasury Secretary Paulson and Fed Chairman Bernanke decided to save AIG by lending it $85 billion and taking an 80% stake in the ownership of the company. On September 20th Secretary Paulson revealed his plan to save the banking system. It was a three page document that essentially called on Congress to turn over $700 billion, which he would use to buy bad debts from banks.  The document stated that he was not to be subject to review or legal action. Americans were outraged. Calls to Congress were 99% opposed.  Virtually the entire political and media establishment lined up to pass the bill. On Sept. 29th 2008 the House voted against the bailout.  The stock market plunged. Paulson refused to give ground on objections. On October 3, 2008, the Mortgage Bailout Plan was passed.  Having been given the authority to act, Paulson chose not to. Previously he had warned that every day that action was delayed would mean more damage to the economy.  When Paulson finally did act, he pursued a completely different plan than the one that he insisted was so urgent.  Instead of buying up the bad assets held by banks, Paulson announced that he would directly inject capital into the banking system and take an equity stake in exchange.  Perhaps the most conservative administration ever was partially nationalizing the nation’s banks.

Government Reaction Under President Obama

When President Obama took office the number issue on his agenda was the economy. President Obama surrounded himself with insiders from Wall Street and the financial sector because he believed that they knew what was needed to be done to fix the economy. Critics said he hired the same people that caused the crisis to fix it.  Timothy Geithner was hired as the Treasury Secretary. Larry Summers was hired as his chief economic advisor. As Treasury Secretary under President Clinton, Summers oversaw the banking deregulation which served the country since the 1930’s.   Robert Rubin, former CEO of Cititgroup,  and Treasury Secretary under President Clinton, was main architect along with Phil Gramm of abolishing the Glass-Steagall Act.  Before his government service, Rubin served 26 years at the investment bank Goldman Sachs.  Many political and economic observers believe this is a case of the “fox guarding the henhouse”.

President Obama’s first large scale response to the financial crisis was getting his stimulus package passed. On February 17, 2009, the American Recovery and Reinvestment Act of 2009 was passed.  The bill contained $787 billion worth of spending money  for education, social welfare, unemployment benefits, infrastructure, and tax cuts. The reaction to the stimulus package has been mixed. The Obama Administration states that the American economy is starting to see the benefits from the bill. On July 10, 2009, despite persistently high unemployment, Treasury Secretary Timothy Geithner said before a House committee that the Obama administration’s economic stimulus plan is on the “expected path.”  However, many political leaders at the state level, economists, and the general public have been critical, stating that very little of the stimulus money has been spent and that the amount of money set aside to stimulate the economy was too small.

The financial deregulation that began in the 1980’s produced three  products that heavily influenced the financial crisis that began in 2008.  Click on the links below to learn more about them.

Credit Default Swaps (CDS)

Collateral Debt Obligations (CDO)

Subprime Mortgages

 

Definitions of Terms Used in Covering of the Financial Crisis

Below are definitions to some of the terms that are used in the media when describing the current financial crisis.

Adjustable –rate mortgage (ARM): a mortgage with an interest rate that changes depending on market interest rates. Typically, ARMs are reset every year depending on the market interest rates in the three-month period prior to the reset date.

Commodities:  products that can be sold in large quantities without important qualitative variations. Commodities exist primarily of agricultural goods and raw materials, as well as some basic industrial inputs, such as steel or lumber.

Credit Default Swaps:  a type of insurance against bond defaults. Use of this newly created instrument exploded during the years of the housing bubble. The issuer of a credit default swap agrees to pay the holder in the event that there is a default on the insured bond. The bonds covered include corporate and government bonds and mortgage-backed securities.

Derivative instruments:  financial instruments that derive their value by being tied to other instruments. For example, an option on currency is a derivative instrument because it gives its holder the right to buy currency at a certain price at date in the future.

Derivative markets: the markets for trading derivative instruments.  In some cases, for example options and futures on commodities, there are well-developed exchanges, such as the Chicago Board of Trade.  However, in other cases, most notably credit default swaps, the markets usually consist of trades directly between banks and other actors.

Federal Runds rate:  the interest rate that banks charge each other to borrow money overnight in order to meet their reserve requirement.  This rate is most directly under the control of the Federal Reserve Board and is its main instrument for controlling the economy.

Financial sector:  the sector of the economy that includes banks, insurance companies, real estate companies, and other businesses whose primary activity involves mediating between the buying and selling of items as opposed to directly providing a good or service.

Hedge funds: investment funds that operate outside most regulatory structures. Hedge funds are not subject to the disclosure requirements of mutual funds, pension funds, or most other pools of capital.

Margin requirement:  The limit often imposed by the Federal Reserve Board to the extent brokerage houses can allow their customers to borrow money to buy stock.  Margin borrowing is using borrowed money to buy stock.

Mortgage-backed securities:  bonds that are backed by a set of mortgages. These bonds will typically involve claims on the interest, the principle, or both of hundreds of mortgages. These claims in turn provide the basis for regular interest payments on mortgage-backed securities.

Options: the right to buy or sell an item, such as a commodity, currency, or stock, at a specific price at a specific time.

Perverse incentives:  incentives that encourage people to engage in economically harmful activities. For example, if mortgage issuers are paid for the number of mortgages they issue, regardless of whether borrowers can repay the mortgage, they will have an incentive to issue mortgages that can’t be repaid.

Secondary Market:  the market for reselling an asset after its original sale.  For example, the stock market is a secondary market for reselling shares of stock after companies have originally sold them.  In the mortgage market, the secondary market is where the issuer of the mortgage sells a mortgage.

Sub-prime mortgages:  mortgages offered primarily to borrowers with poor credit histories, sub-prime loans typically had interest rates 2 to 4 percent higher than prime loans. Sub- prime mortgages went from 9% of mortgages in 2002 to 25% of mortgages in 2006.

 

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