2008 Financial Crisis

Causes, Costs, and Whether It Could Happen Again

© The Balance 2019

The 2008 financial crisis was the worst economic disaster since the Great Depression of 1929. It occurred despite the efforts of the Federal Reserve and U.S. Department of the Treasury. The crisis led to the Great Recession, where housing prices dropped more than the price plunge during the Great Depression. Two years after the recession ended, unemployment was still above 9%. That doesn't count those discouraged workers who had given up looking for a job. 

Causes of the Crisis

In 2006, housing prices started to fall for the first time in decades. At first, realtors applauded. They thought the overheated real estate market would return to a more sustainable level. They didn't realize there were too many homeowners with questionable credit. In addition, banks had approved loans for 100% or more of the home's value.

Many blamed the Community Reinvestment Act, which pushed banks to make investments in subprime areas. Several studies by the Federal Reserve found it did not increase risky lending.

Others blamed Fannie Mae and Freddie Mac for the entire crisis. To them, the solution is to close or privatize the two agencies. If they were shut down, the housing market would collapse because they guarantee the majority of mortgages.

Deregulation of financial derivatives was a key underlying cause of the financial crisis.

Two laws deregulated the financial system. They allowed banks to invest in housing-related derivatives. These complicated financial products were so profitable they encouraged banks to lend to ever-riskier borrowers. This instability led to the crisis.

The Financial Services Modernization Act of 1999 (Gramm-Leach-Bliley Act) allowed banks to use deposits to invest in derivatives. Bank lobbyists said they needed this change to compete with foreign firms. They promised to only invest in low-risk securities to protect their customers. As banks chased the profitable derivative market, they didn't keep this promise.

The Commodity Futures Modernization Act exempted derivatives from regulatory oversight. It also overruled any state regulations. Big banks had the resources to manage these complicated derivatives.

Among these products, mortgage-backed securities (MBS) had the most impact on the housing market. The profitability of MBS created more demand for the mortgages they were based upon.

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

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

Stodgy pension funds bought these risky assets because they thought an insurance product called credit default swaps protected them. Insurance company American Insurance Group (AIG) sold these swaps, and when the derivatives lost value, they didn't have enough cash flow to honor all the swaps. 

In 2007, banks began to panic once they realized they would have to absorb the losses, and they stopped lending to each other. They didn't want other banks to give them worthless mortgages as collateral, and as a result, interbank borrowing costs, called Libor, rose. The Federal Reserve began pumping liquidity into the banking system via the Term Auction Facility, but that wasn't enough.

Cost of the Crisis

The chart below shows a breakdown of how much the 2008 financial crisis cost.

The 2008 financial crisis timeline began in March 2008, when investors sold off their shares of investment bank Bear Stearns because it had too many of the toxic assets. Bear approached JP Morgan Chase to bail it out, but the Fed had to sweeten the deal with a $30 billion guarantee. The situation on Wall Street deteriorated throughout the summer of 2008.

Congress authorized the Treasury Secretary to take over mortgage companies Fannie Mae and Freddie Mac—which cost it $187 billion at the time. On September 16, 2008, the Fed loaned $85 billion to AIG as a bailout. In October and November, the Fed and Treasury restructured the bailout, bringing the total amount to $182 billion. By 2012, the government made a $22.7 billion profit when the Treasury sold its last AIG shares. 

On September 17, 2008, the crisis created a run on money market funds where companies parked excess cash to earn interest on it overnight, and banks then used those funds to make short-term loans. During the run, companies moved a record $172 billion out of their money market accounts into even safer Treasury bonds.

If the nation's money market accounts had gone bankrupt, business activities and the economy would have ground to a halt. That crisis called for massive government intervention.

Three days later, Treasury Secretary Henry Paulson and Fed Chair Ben Bernanke submitted a $700 billion bailout package to Congress. Their fast response helped stopped the run, but Republicans blocked the bill for two weeks because they didn't want to bail out banks. They only approved the bill on Oct.1, 2008, after global stock markets almost collapsed. 

Troubled Asset Relief Program

The bailout package never cost taxpayers the full $700 billion. The Treasury disbursed $441.8 billion from the Troubled Asset Relief Program (TARP), and by 2018, it had put $442.7 billion back into the fund, making $900 million in profit. It did this by buying shares of the companies it bailed out when prices were low and wisely selling them when prices were high.

The TARP funds helped in five areas:

  • $245.1 billion was used to buy bank preferred stocks as a way to give them cash
  • $79.7 billion bailed out auto companies  
  • $67.8 billion went to the $182 billion bailout of AIG  
  • $19.1 billion went to shore up credit markets. The banks repaid $23.6 billion, creating a $4.5 billion profit  
  • The Homeowner Affordability and Stability Plan disbursed $30.1 billion to modify mortgages  

President Barack Obama didn't use the remaining $700 billion allocated for TARP because he didn't want to bail out any more businesses. Instead, he asked Congress for an economic stimulus package. On February 17, 2009, he signed the American Recovery and Reinvestment Act, which included tax cuts, stimulus checks, and public works spending. By 2011, it put $831 billion directly into the pockets of consumers and small businesses—enough to end the financial crisis by July 2009. 

How It Could Happen Again

Congress passed the Dodd-Frank Wall Street Reform Act to prevent banks from taking on too much risk. It also allows the Fed to reduce bank size for those that become too big to fail.

Meanwhile, banks keep getting bigger and are pushing to minimize or get rid of even this regulation. The financial crisis of 2008 proved that banks could not regulate themselves. Without government oversight like Dodd-Frank, they could create another global crisis. 

Securitization, or the bundling and reselling of loans, has spread to more than just housing. To prevent further destabilization, stronger regulations of these derivatives should be considered. 

Article Sources

  1. Bureau of Labor Statistics. "Unemployment in September 2011," Accessed May 5, 2020.

  2. U.S. Department of the Treasury. "The Financial Crisis Response in Charts," Page 3. Accessed May 5, 2020.

  3. U.S. Department of Housing and Urban Development. "U.S. Housing Market Conditions," Page 4. Accessed May 5, 2020.

  4. Federal Reserve. "Assessing the Community Reinvestment Act's Role in the Financial Crisis," Accessed May 5, 2020.

  5. U.S. Government Publishing Office. "Public Law 106–102—Nov. 12, 1999: Gramm–Leach–Bliley Act," Accessed May 5. 2020.

  6. University of Arkansas. "Impact of the Gramm-Leach-Bliley Act," Accessed May 5, 2020.

  7. Congress.gov. "H.R.5660 - Commodity Futures Modernization Act of 2000," Accessed May 5, 2020.

  8. SEC. "Commodity Futures Modernization Act of 2000," Page 7. Accessed May 5, 2020.

  9. SEC. "Mortgage-Backed Securities and Collateralized Mortgage Obligations," Accessed May 5, 2020.

  10. FDIC. "Crisis and Response: An FDIC History, 2008­–2013," Page 5. Accessed May 5, 2020.

  11. FDIC. "Crisis and Response: An FDIC History, 2008­–2013," Page 27. Accessed May 5, 2020.

  12. Journal of Economic Perspectives. "Deciphering the Liquidity and Credit Crunch 2007–2008," Page 85. Accessed May 5, 2020.

  13. Journal of Economic Perspectives. "Deciphering the Liquidity and Credit Crunch 2007–2008," Page 88. Accessed May 5, 2020.

  14. U.S. Department of the Treasury. "Investment in AIG," Accessed May 5, 2020.

  15. U.S. Department of the Treasury. “Treasury Department Announces Further Steps to Expedite Wind Down of Fannie Mae and Freddie Mac,” Accessed May 5, 2020.

  16. Journal of Economic Perspectives. "When Safe Proved Risky: Commercial Paper During the Financial Crisis of 2007-2009," Page 41. Accessed May 5, 2020.

  17. Congressional Research Service. "Proposal to Allow Treasury to Buy Mortgage-Related Assets to Address Financial Instability," Page 1. Accessed May 5, 2020.

  18. The Federal Reserve Board. "The Cross Section of Money Market Fund Risks and Financial Crises," Accessed May 5, 2020.

  19. U.S. Department of the Treasury. “TARP Tracker From November 2008 to January 2020,” Accessed May 5, 2020.

  20. U.S. Department of the Treasury. “TARP Tracker From November 2008 to January 2020: AIG,” Accessed May 5, 2020.

  21. U.S. Department of the Treasury. “TARP Tracker From November 2008 to January 2020: Housing,” Accessed May 5, 2020.

  22. U.S. Department of the Treasury. “Homeowner Affordability and Stability Plan Fact Sheet,” Accessed May 5, 2020.

  23. Congressional Budget Office. “Estimated Impact of The American Recovery and Reinvestment Act on Employment and Economic Output From October 2011," Page 9. Accessed May 5, 2020.

  24. Brookings Institute. "An Address on Jobs and the Economy by President Barack Obama," Accessed May 5, 2020.

  25. S&P Global. "Ten Years Later, World's Biggest Banks Keep Getting Bigger," Accessed May 5, 2020.

  26. U.S. Government Publishing Office. "Dodd-Frank Wall Street Reform and Consumer Protection Act," Pages 29-32. Accessed May 5, 2020.

  27. Congressional Budget Office. "Fannie Mae, Freddie Mac, and the Federal Role in the Secondary Mortgage Market," Page IX. Accessed May 5, 2020.